SOUTHERN  BRANCH, 
UNIVERSITY  OF  CALIFORNIA, 

LIBRARY, 

1^9  ANGELES.  CALIF. 


DEPRECIATION 

OF 

PUBLIC  UTILITY  PROPERTIES 


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DEPRECIATION 


OF 


PUBLIC   UTILITY   PROPERTIES 

AND 

Its  Relation  to  Fair  Value  and 
Changes  in  the  Level  of  Prices 


BY 

HENRY  EARLE  RIGGS,  A.B.,  C.E. 

MEMBER    AMERICAN     INSTITUTE   OP   CONSULTING    ENGINEERS,    MEMBER    AMERICAN 
SOCIETY   OF   CIVIL   ENGINEERS,    MEMBER    AMERICAN     RAILWAY     ENGINEEB- 
INQ     ASSOCIATION,     MEMBER     AMERICAN     ECONOMIC     ASSOCIATION, 
MEMBER   AMERICAN   ASSOCIATION   FOB  THE   ADVANCEMENT 
OF  SCIENCE,  ETC.      PROFESSOR  OF  CIVIL  ENGINEER- 
ING,  UNIVEBSITY  OF  MICHIGAN. 


FiBBT  Edition 


4 


79nr> 


McGRAW-HILL  BOOK  COMPANY,  Inc. 

NEW  YORK:  370  SEVENTH  AVENUE 

LONDON:  6  4  8  BOUVERIE  ST.,  E.  C.  4 

1922 


copthiqht  1922.  by  the 
McGhaw-Hill  Book  Company,  Inc. 


t^  PREFACE 

V 

The  regulation  of  public  utilities  in  the  United 
States  is  a  development  of  recent  years  and  is  still 
in  the  period  of  formation  and  establishment  of  rules 
n  of  practice. 

^.     The  great  war,  with  its  unsettling  of  business  con- 
ditions,  and   the   violent   price   fluctuations   which 
accompanied  and  followed  the   actual  war  period 
have  introduced  new  complications  into  some  of  the 
problems  which  were  being  dealt  with  by  Regulating 
vj'  Commissions  and  Courts  just  at  a  time  when  it 
\^  appeared    that    definite    conclusions    were    being 
"^  reached. 

^      Valuation  and  Depreciation,  and  the  accounting 

5  methods  which  deal  with  these  subjects,  have  been 

^  greatly  complicated  by  the  price  fluctuations  of  the 

^    period   1914   to   1921.     New   questions   have   been 

^    raised,  new  arguments  have  been  introduced  and  it 

would  appear  that  some  conclusions  are  in  danger 

of  being  reached  which  may  have  a  far  reaching 

effect  upon  utility  properties  through  the  weakening 

of  the  stability  of  valuations  already  established, 

and  the  ultimate  wiping  out  of  a  large  part  of  the 

actual  investments  necessarily  made  in  extensions  of 

property  during  the  period  of  high  prices. 

The  writer  has  come  into  contact  with  a  number 
of  these  problems  and  has  studied  their  recent  com- 
plications, in  different  parts  of  the  country,  on  dif- 


vi  PREFACE 

ferent  properties,  under  a  number  of  different  con- 
ditions. His  first  work  on  public  utility  valuation 
was  as  assistant  to  M.  E.  Cooley  in  the  1900  Michi- 
gan valuation.  His  subsequent  connection  with  this 
class  of  work  has  not  been  confined  to  one  side  of  the 
case  or  to  one  character  of  controversy,  but  as  en- 
gineer for  corporations  in  some  cases,  for  cities  and 
other  public  corporations  representing  the  rate 
payers  and  general  tax  payers  in  others,  for  the  pub- 
lic utility  commissions  of  two  states  in  other  cases, 
and  as  arbitrator  in  several  cases  which  have 
involved  rate  making,  taxation,  authorization  of 
capital  and  sale  of  property,  he  has  had  a  good 
opportunity  of  studying  a  number  of  different 
angles  of  these  questions. 

It  would  seem  that  an  attempt  to  consider  the 
subjects  of  Fair  Value  and  Depreciation  from  an 
entirely  unprejudiced  viewpoint  and  without  the 
issues  of  any  particular  case  in  mind  is  appropriate 
at  this  time.  The  following  pages  represent  an 
effort  to  set  forth  the  writer 's  views  and  conclusions 
as  they  have  developed  in  connection  with  a  practice 
of  over  twenty  years,  and  to  present  the  various 
arguments  which  have  been  considered  by  him  in 
reaching  those  conclusions.  This  work  has  been 
done  as  part  of  a  sincere  attempt  to  find  that  middle 
ground  of  absolute  fairness  and  justice  which  must 
be  determined  before  the  public  utility  issue  may  be 
considered  as  reasonably  settled. 

Many  hundreds  of  men  have  been  brought  into 
contact  with  valuation  work  for  the  first  time 
through  their  employment  on  some  large  appraisal. 
Many  of  these  men  have  lacked  a  knowledge  of  the 


PREFACE  vii 

legal  decisions  bearing  on  the  relationships  between 
owner  of  property  and  consumer  or  patron.  It 
would  therefore  seem  that  there  is  justification  for 
such  a  book. 

The  attempt  is  here  made  to  trace  briefly  the 
history  of  regulation  of  utilities,  to  present,  as  the 
writer  sees  it,  the  true  conception  of  ''depreciation" 
as  that  word  has  been  used  in  valuation  and  regula- 
tion practice,  and  to  point  out  certain  important 
conclusions  of  the  courts  with  which  every  one  en- 
gaged in  valuation  work  ought  to  be  familiar. 

The  Appendix  presents  the  various  decisions  at 
considerable  length,  in  so  far  as  they  deal  with  the 
subject  of  depreciation.  The  decisions  are  arranged 
in  chronological  order,  since  in  that  way  they  clearly 
show  the  drift  of  legal  opinion  as  the  subject  of 
valuation  has  developed. 

Henry  Earle  Riggs. 
Ann  Arbor,  Michigan. 
July,  1922. 


CONTENTS 

PAGB 

Preface  v 

CHAPTER 

I.     The    Problems    of    Eegulation 1 

II.     Investment  in  Public  Utility  Properties    ...  7 

III.  The  Interest   of  the  Rate  Payer  in   the  Property  18 

IV.  Operating   Expenses 25 

v.     "War  Period  Price  Fluctuations 33 

VI.     Fair  Value  and  the  Rate  of  Return  ....  43 

VII.     Fluctuating  Prices  and  Accounting  Allowances  for 

Replacement 63 

VIII.     Supreme  Court  Decisions  Bearing  on  Depreciation  68 

IX.     Divergent  Views  as  to  the  Propriety  of  Accounting 

Reserves 78 

X.     The  Uncertain  Character  of  Depreciation  Estimates  93 

XI.     Depreciation — Loss  of  Value  Which  Should  Be  De- 
ducted       106 

XII.     Obsolescence 131 

XIII.     Conclusion 141 

Appendix.     Depreciation  in  the  Decisions  of  the  Supreme  Court 

and  of  the  United  States  Courts   ....  147 

Table  of  Cases  and  References 209 


DEPRECIATION  OF  PUBLIC 
UTILITY  PROPERTIES 


CHAPTER  I 
THE  PROBLEMS  OF  REGULATION 

The  regulation  of  public  utilities  by  the  National 
and  State  governments  in  the  United  States  is  a 
development  of  the  last  half  century,  although  the 
principles  of  law  under  which  it  is  justified  have 
been  recognized  for  five  hundred  years  or  more. 

A  very  brief  outline  of  the  history  of  American 
utility  regulation  and  the  causes  which  led  up  to  it 
is  essential  to  a  complete  understanding  of  the  argu- 
ment which  is  presented  in  the  following  chapters. 

The  steam  railroads,  the  largest  group  of  pri- 
vately owned  utilities  which  are  engaged  in  serving 
the  people,  may  fairly  be  said  to  have  been  in  very 
large  measure  responsible  for  the  development  of 
public  utility  regulation  in  the  United  States.  Prac- 
tically every  evil  that  has  ever  been  complained  of, 
such  as  over-capitalization,  excessive  rates,  dis- 
crimination, corporation  wrecking,  manipulation  of 


2        DEPRECIATION  OF  PUBLIC  UTILITIES 

securities,  combinations,  rebating,  speculation  and 
bad  accounting  practice  has  been  laid  at  the  door 
of  the  railroads.  The  early  legislation  which  re- 
sulted in  the  creation  of  the  various  state  commis- 
sions and  the  Interstate  Commerce  Commis- 
sion was  the  direct  result  of  many  arbitrary  and 
injurious  acts  of  the  railroads  which  aroused  a 
storm  of  opposition  and  caused  the  people  of  a  large 
section  of  the  country  to  seek  relief.  A  review  of 
railroad  history  is  in  fact  a  review  of  the  growth 
of  our  laws  on  the  subject  of  regulation  and  of  the 
creation  of  the  machinery  for  putting  regulation  into 
effect. 

The  first  railroad  in  the  world  was  opened  to 
traffic  September  15,  1830,  less  than  one  hundred 
years  ago.^ 

The  period  from  1830  to  1850  marked  the  estab- 
lishment of  the  railroad  as  the  principal  transpor- 
tation agency  of  the  country,  demonstrated  its 
superiority  over  the  canal,  established  its  credit  as 
having  a  capacity  for  earning  good  returns,  and 
gave  it  standing  as  sound  security  for  loans  in  the 
form  of  bond  issues. 

The  second  period  from  about  1850  to  about  1870 
may  properly  be  called  the  era  of  expansion  and 
development,  and  marked  (except  for  the  four 
years  of  war)  a  rapid  growth  in  mileage,  especially 
in  the  central  states. 

Following  this,  and  merging  into  it  came  a  period 
ending  just  prior  to  1890  which  may  properly  be 

^  Charles  Francis  Adams,  Origin  and  Problems  of  Railroads,  "The 
Genesis  of  the  Railroad  System." 


THE  PROBLEMS  OF  REGULATION   3 

called  the  era  of  speculation  and  discrimination.  It 
was  the  period  of  greatest  railroad  growth  and  ex- 
pansion. Thousands  of  miles  of  new  lines  were  built 
each  year.  There  was  at  the  outset  no  governmental 
control  over  the  railroads.  Earlier  acts  of  railroad 
oppression  appear  to  have  developed  into  a  perfect 
riot  of  combination,  discrimination,  extortion  and 
rebating.  The  people  of  the  central  west  retaliated. 
The  grange  movement  organized  about  1870  spread 
like  wildfire  and  in  a  short  time  exerted  a  tremen- 
dous influence  in  politics.  The  bursting  of  the 
bubble  of  inflated  values  and  inflated  credit  by  the 
panic  of  1873  created  conditions  in  many  localities 
which  approached  actual  warfare  between  the  pro- 
ducers and  railroads.  Laws  were  passed  in  many 
states  known  as  *' granger  legislation"  reducing  rail- 
road rates  and  inflicting  requirements  on  the  rail- 
road, many  of  which  were  just  as  bad  as  the  acts 
of  the  railroads  which  gave  rise  to  the  laws.^ 

During  the  period  from  1873  to  1890  many  cases 
reached  the  Supreme  Court  and  one  after  another 
the  principles  of  law  were  stated  which  clarified  the 
situation  and  established  fully  the  right  of  the  gov- 
ernment  to    regulate    the   corporations.^     Several 


Tor  complete  details  regarding  these  matters,  see:  Hepburn  Com- 
mittee Report,  N.  Y.  Legislature,  1879;  Report  of  Select  Committee 
of  the  U.  S.  on  Interstate  Commerce,  49th  Congress,  1st  Session; 
Railway  Problems,  Wm.  Z.  Ripley,  1907;  The  Heart  of  the  Railroad 
Problem,  Frank  Parsons,  1906;  Wealth  Against  Commonwealth, 
Lloyd;   History  of  Standard  Oil,  Ida  M.  Tarbell. 

'  Munn  vs  Illinois,  94  U.  S.  113  (1876)  and  accompanying  cases,  94 
U.  S.  155;  94  U.  S.  164;  94  U.  S.  179;  94  U.  S.  180;  94  U.  S.  181. 
Stone  vs  Farmers'  Loan  and  Trust  Company,  116  U.  S.  307,  1881.     Chi- 


4        DEPRECIATION   OF  PUBLIC  UTILITIES 

more  or  less  futile  early  railroad  commissions  were 
established  between  1875  and  1885,  and  finally,  in 
1887  the  Interstate  Commerce  Commission  was 
created  and  the  machinery  for  nation-wide  control 
of  the  railroads  was  set  in  motion. 

The  fourth  period  of  railroad  history,  commencing 
from  1887  to  1890,  and  extending  to  the  present 
time,  may  be  termed  the  period  of  regulation.  The 
Interstate  Commerce  Commission  has  grown  in 
power  and  influence  and  has  done  splendid  work. 
The  older  state  commissions  have  been  reorganized, 
and  many  new  ones,  organized  along  new  and 
broader  lines,  have  extended  their  control  to  other 
public  utilities  than  the  railroads  and  have  made 
great  progress  in  the  settlement  of  many  of  the 
questions  which  had  been  causing  friction.  The 
utilities  have  quite  generally  come  to  a  realization 
of  the  many  benefits  which  they  themselves  derive 
from  regulation,  and  there  has  grown  up  a  better 
understanding  of  the  relationships  between  the  util- 
ities, their  patrons  and  the  regulating  bodies. 

Regulation  of  utilities  is  indeed  a  new  thing.  Its 
beginning  dates  back  to  the  years  between  1885  and 
1890,  but  a  little  over  thirty  years.  The  uniform 
accounting  law  went  into  effect  in  1907,  only  fifteen 
years  ago,  and  the  large  development  of  corporation 
accounting  regulation  has  been  since  that  time. 

The  Knoxville  waterworks  decision  which  was 
handed  down  in  1909  marks  the  beginning  of  a  defi- 

cago,  Milwaukee  and  St.  Paul  Railway  Company  vs  Minnesota,  134  U.  S. 
418  (1890);  Reagan  vs  Farmers'  Loan  and  Trust  Company,  154  U.  S.  362 
(1894). 


THE  PROBLEMS  OF  REGULATION    5 

nite  era  in  regulation  and  accounting  because  it 
was  the  first  authoritative  recognition  of  the  neces- 
sity for  providing  for  depreciation  or  replacement. 

The  first  large  work  of  valuation  undertaken  in 
the  United  States  was  the  Cooley  railroad  appraisal 
in  Michigan  in  1900,  followed  during  the  next  six 
or  seven  years  by  similar  work  in  a  number  of  other 
states. 

The  work  of  public  utility  regulation  is  still  de- 
cidedly in  the  formative  period,  many  principles 
have  yet  to  be  established,  many  details  of  engineer- 
ing and  accounting  practice  have  yet  to  be  worked 
out.  Some  old  methods  need  to  be  discarded  and 
some  theories  which  have  been  given  weight  need 
reappraisal  in  the  light  of  the  conditions  now  exist- 
ing. 

Among  the  subjects  most  prominently  before 
commissions  at  the  present  day  are  those  relating 
to  valuation  and  depreciation. 

"What  is  the  correct  method  for  determining  "fair 
value"  for  rate  making  and  other  purposes? 

What  methods  shall  be  adopted  for  the  determi- 
nation of  "depreciation,"  in  the  sense  that  the  word 
is  construed  to  mean  a  proper  provision  for  the  re- 
placement of  units  of  property  when  they  are  worn 
out,  so  that  the  integrity  of  the  investment  may  be 
maintained? 

How  shall  the  accounting  for  replacement  be 
done? 

What  methods  shall  be  adopted  for  the  determi- 
nation of  "depreciation,"  in  the  sense  that  the  word 


6        DEPRECIATION   OF   PUBLIC   UTILITIES 

is  used  to  mean  loss  of  value  whicli  shall  be  deducted 
in  fixing  ''fair  value"? 

What  is  the  effect  on  all  of  these  questions  of 
the  recent  changes  in  the  price  level,  or  the  fluctua- 
tion in  the  value  of  money? 

How  shall  accounting  rules  be  modified,  if  at  all, 
to  meet  the  conditions  brought  about  by  the  change 
of  price  level? 

It  is  to  these  questions  that  consideration  is  given 
in  the  following  pages. 


CHAPTEE  II 
INVESTMENT  IN  PUBLIC  UTILITY  PROPERTIES 

There  are  certain  kinds  of  service  which  have 
become  absolutely  essential  to  our  present-day  civ- 
ilization, which  are  of  such  a  character  that  the 
individual  cannot  furnish  them  for  himself.  These 
services  are  necessarily  rendered  under  conditions 
of  substantial  monopoly.  They  may  be  had  in  one 
of  two  ways.  Either  government  may  build  and 
operate  them,  or  private  capital  may  be  induced 
to  build  and  operate  them  subject  to  government 
regulation. 

It  is  definitely  settled  that  where  private  capital 
does  undertake  to  build  one  of  these  quasi  public 
utilities  and  accepts  a  franchise,  it  places  itself 
under  obligation  to  build  a  property  suitable  and 
sufficient  to  render  the  service,  to  maintain  the 
property  always  in  a  safe  and  adequate  condition 
to  render  the  service,  and  to  operate  the  property 
at  all  times  in  such  manner  as  to  furnish  the  service. 
Upon  the  state  there  rests  the  obligation  not  to  im- 
pair the  grant. 

The  obligation  resting  upon  the  utility  company 
is  such  that  it  must  maintain  its  property  at  all 
times  in  a  condition  as  fully  adequate  to  render  the 

7 


8        DEPRECIATION  OF  PUBLIC  UTILITIES 

service  it  has  undertaken  to  perform  as  when  it 
was  first  installed.  While  the  obligation  endures, 
service  must  be  given,  and  the  property  must  be 
kept  in  condition  to  give  it.  The  property  cannot 
be  sold  or  leased,  except  as  coupled  with  the  obliga- 
tion. The  obligation  compels  the  owner  to  replace 
parts  of  the  property  as  they  decay  so  that  the  prop- 
erty as  one  composite  instrument  of  service  may 
never  deteriorate  far  enough  to  impair  efficiency  or 
safety  of  service,  and  the  obligation  is  devoted  to  the 
service  of  the  public  just  as  truly  as  the  property  is. 
The  property  is  security  for  the  performance  of  the 
obligation.  The  courts,  through  their  receivers  have 
in  many  instances  made  large  expenditures  on  prop- 
erties to  put  them  in  adequate  condition  to  render 
the  service,  and  such  expenditures  have  been  im- 
posed as  a  paramount  lien  on  the  properties. 

It  would  seem  to  be  clear  that  the  obligation  to 
maintain  the  property  is  such  that  it  offsets  the 
progress  toward  replacement  of  parts  of  the  prop- 
erty. Even  granting  that  it  were  true  that  the  ob- 
ligation to  replace  is  of  no  value  to  the  public  until 
the  necessity  arises  for  its  performance,  it  is  equally 
true  that  the  theoretical  deterioration  or  loss  of 
service  life  is  of  no  detriment  to  the  public  until 
necessity  arises  for  its  replacement,  and  it  would 
be  an  economic  wrong  and  undue  hardship  on  the 
user  (who  must  pay  for  it)  to  replace  before  there 
was  a  necessity  to  do  so. 

This  obligation  under  the  franchise  has  been  rec- 
ognized by  the  courts  in  a  long  line  of  decisions.  It 
must  be  taken  into  account  and  as  long  as  a  property 


INVESTMENT  IN  PUBLIC   UTILITIES        9 

is  fully  maintained  and  properly  administered,  and 
as  long  as  the  policy  of  the  management  provides 
for  proper  renewals  when  due,  or  provides  other- 
wise a  proper  system  of  accounting  for  reserves 
with  which  to  replace  items  of  property  when  they 
reach  the  ends  of  their  lives,  the  effect  of  the  obliga- 
tion cannot  be  ignored. 

It  is  pertinent  to  inquire  what  the  owners  of  a 
public  utility  secure  when  they  furnish  the  money 
with  which  to  build  a  railroad,  waterworks,  gas 
plant,  electric  plant  or  other  property  destined  to 
furnish  service  of  a  sort  which  compels  it  to  submit 
to  regulation. 

Any  public  utility  which  has  been  built  long 
enough  to  form  its  connections,  secure  its  business, 
and  reach  a  condition  of  maximum  efficiency,  and 
which  is  fully  maintained  to  the  highest  standard 
required  by  its  service,  will  be  found  to  be  made  up 
of  many  different  kinds  of  units  of  property.  Some 
of  these  units,  or  the  items  composing  them,  will 
be  found  to  be  new,  some  will  be  old  and  ready  to 
be  replaced  and  some  will  be  found  to  be  in  all 
stages  intermediate.  This  is  the  normal  condition 
of  all  properties  which  are  fully  maintained.  This 
is  the  maximum  condition  that  could  be  hoped  for 
when  the  owners  started  out  to  make  the  investment. 
This  property  cost  the  entire  amount  of  money 
which  was  spent  for  plant.  It  is  folly  to  assume 
that  such  a  thing  as  a  hypothetical  ''new  property" 
is  what  was  sought.  No  one  ever  started  out  to 
build  just  simply  a  "new  property."  No  one  can 
ever  possess  a  utility  property  all  of  whose  parts 


10      DEPRECIATION   OF   PUBLIC   UTILITIES 

are  "neiv/'  and  if  such  a  thing  were  possible  it  could 
not  be  kept  so.  It  would  be  criminal  economic  waste 
to  discard  perfectly  good  property  units  merely  be- 
cause they  are  not  "new."  If  newness  were  the 
ideal,  and  if  all  lack  of  newness  w^ere  to  be  computed 
on  the  basis  of  a  guess  as  to  probable  life  and  de- 
ducted from  capital  on  which  returns  could  be 
earned,  how  many  properties  would  be  financed? 
What  inducement  could  be  offered  to  capital  to  en- 
courage it  to  seek  this  field  of  investment?  The 
answer  appears  to  be  obvious.  Capital  would  not 
flow  to  the  public  utility  field. 

The  hypothetical  "new  property"  was  simply  a 
device  of  the  engineers  engaged  in  early  valuation 
practice  to  enable  them  to  form  rational  estimates 
of  condition  or  so-called  "depreciation,"  a  subject 
which  will  be  discussed  later. 

The  various  courts  and  commissions  in  dealing 
with  the  subject  of  valuation  have  had  to  work  out 
many  complex  cases  in  which  all  sorts  of  arguments 
have  been  presented. 

Erroneous  construction  of  certain  court  and  com- 
mission decisions  by  attorneys  and  engineers; 
claims  for  the  deduction  of  value  on  account  of 
purely  theoretical  accrued  loss  of  service  life;  the 
setting  up  of  different  valuations  of  the  same  prop- 
erty at  the  same  time  for  different  purposes,  such 
as  rate  making,  capitalization,  taxation  or  sale ;  are 
among  the  confusing  issues  that  have  been  injected 
into  these  cases. 

"Fair  value,"  as  that  term  has  been  used  by  the 
courts,  must  be  defined.    As  value  must  depend  on 


INVESTMENT  IN  PUBLIC  UTILITIES      11 

property  and  income,  necessarily  a  public  service 
property  is  worth  no  more  than  the  sum  of  money 
upon  which  it  is  allowed  to  earn  a  reasonable  return. 

Those  who  hold  that  there  is  one  value  for  pur- 
poses of  ratemaking  and  another  for  purposes  of 
sale,  or  the  state  officials  who  argue  a  low  value  for 
rates  and  a  higher  value  for  taxes,  will  find  grave 
difficulty  in  convincing  the  owner  of  money  of 
the  propriety  of  investing  his  money  in  any  property 
which  costs  more  than  it  is  allowed  to  earn  upon. 
The  corporation  managers  who  in  the  past  have 
devoted  time,  energy  and  money  to  trying  to  prove 
a  low  valuation  for  purposes  of  taxation,  instead  of 
recognizing  the  necessity  for  correct  valuation  and 
of  adequate  rates  to  enable  them  to  pay  their  taxes, 
have  done  much  to  add  to  the  confusion. 

Much  of  the  indefiniteness  regarding  the  weight 
to  attach  to  certain  court  or  commission  decisions, 
or  regarding  the  proper  interpretation  of  some  of 
them,  is  undoubtedly  due  to  the  fact  that  conditions 
surrounding  the  different  properties  are  so  ex- 
tremely variable. 

One  property,  located  in  a  community  which  is 
growing  rapidly  and  which  has  a  population  which 
uses  the  product  of  the  utility  liberally,  may  not  be 
at  all  comparable  with  a  similar  property  located 
in  a  dead  community  where  there  is  but  small  de- 
mand for  the  product. 

Unless  good  judgment  has  been  used  in  making 
the  investment,  and  the  plant  was  either  built  in 
response  to  a  real  need  for  the  product,  or  the  build- 
ing of  the  plant  developed  other  industry  so  that 


12      DEPRECIATION   OF  PUBLIC  UTILITIES 

the  market  for  the  product  was  created  by  the  con- 
struction, it  is  not  to  be  expected  that  the  public 
l^'  can  be  required  to  guarantee  returns.  The  public 
cannot  be  expected  to  underwrite  the  losing  venture, 
or  the  unwise,  imprudent  or  injudicious  investment. 

In  the  case  of  the  property  which  was  built  in 
response  to  a  reasonable  need,  it  is  definitely  settled 
that  the  owner  may  expect  rates  which  will  cover 
all  operating  costs  including  enough  to  maintain  the 
investment  intact,  and  in  addition  a  fair  return  upon 
''fair  value."  Certain  clear  principles  of  account- 
ing for  capital  expenditures,  and  for  replacement 
of  property  charged  to  capital,  appeared,  before  the 
war,  to  have  been  settled  by  regulating  commissions 
in  such  a  way  that  no  exception  could  be  taken. 
Recent  changes  in  the  price  level  seem  to  have  raised 
a  question  as  to  the  propriety  of  some  of  these  con- 
clusions as  to  accounting. 

All  money  expended  in  the  construction  of  prop- 
erty, which  is  paid  out  for  necessary  costs  inevitable 
in  the  building  of  such  a  plant,  should  be  charged 
to  capital. 

All  money  expended  in  enlargement  or  extensions 
of  the  property  should  be  charged  to  capital  through 
the  additions  and  betterment  account. 

All  money  expended  in  repairing  and  maintaining 
the  property  or  in  replacing  or  renewing  any  of  the 
parts  or  units  of  the  property,  so  that  it  is  kept  in 
the  condition,  as  to  size  and  capacity,  in  which  it 
was  before  the  renewal  was  made,  should  be  charged 
to  operating  expenses. 

The  rate  payers  have  a  right  to  demand  that  no 


INVESTMENT  IN  PUBLIC  UTILITIES      13 

additions  to  property  of  any  kind  or  to  any  extent 
be  made  through  charges  to  operating  expenses. 
The  rate  payer  must  provide  enough  to  maintain 
invested  capital  intact.  He  should  be  protected  from 
any  attempt  to  increase  capital  value  at  his  expense, 
and  without  corresponding  investment  by  the  owner. 

All  property  charged  to  capital  should  be  built 
from  money  that  comes  from  the  investor,  or  from 
money  that  belongs  to  the  investor,  in  the  form  of 
surplus. 

All  expenditures  charged  to  operating  expenses 
should  come  from  the  rate  payers. 

It  must  be  remembered  that  principles  of  eco- 
nomics and  accounting  which  are  applicable  to  the 
great  complex  properties  of  indefinite  or  infinite  life 
such  as  railroads,  electric  railroads,  electric  power, 
telephone  and  gas  properties,  composed  of  thou- 
sands or  hundreds  of  thousands  of  items  and  oper- 
ating units  are  not  so  simple  as  those  which  apply 
in  the  case  of  property  consisting  of  a  single  unit. 
Conclusions  cannot  be  drawn  from  the  case  of  the 
man  with  one  automobile,  who  has  engaged  in  the 
jitney  business,  which  are  applicable  to  the  great 
property  engaged  in  street  railway  transportation 
in  one  of  our  large  cities. 

It  seems  clear  that  we  must  consider  these  prop- 
erties as  vast  complex  composite  instruments  of 
service.  Each  utility  is  one  property,  made  up  of 
hundreds  of  thousands  of  individual  parts,  such  as 
separate  machines,  structures  and  buildings,  which 
may  be  considered  as  units,  but  all  of  these  units 
serve  the  one  purpose  for  which  the  corporation  was 


14      DEPRECIATION  OF  PUBLIC  UTILITIES 

formed.  Each  finds  its  greatest  value  as  a  part 
of  the  whole  property  and  not  as  a  separate  unit. 
The  property  as  a  whole  is  not  an  article  of  com- 
merce with  a  market  price  varying  with  the  varying 
cost  of  its  constituent  elements. 

The  great  property  was  built  under  franchise  to 
render  a  continuing  service.  The  property  as  one 
entity  is  therefore  of  continuing  life  and  in  many 
cases,  like  the  railroads,  of  indefinite  life.  It  must 
continue  to  exist  so  long  as  the  service  is  needed. 

The  Michigan  Central  Railroad  from  Detroit  to 
Chicago  is  seventy-five  years  old.  Its  track  has 
never  ceased  to  function.  The  ties  and  rails  have 
been  changed  many  times.  Its  bridges  have  been 
rebuilt  time  and  again.  The  line  has  been  changed 
in  numerous  places,  old  parts  of  the  road  bed  aban- 
doned and  new  ones  built.  The  property  has  grown 
from  the  primitive  construction  with  wooden  string- 
ers, strap  rail  and  light  equipment  to  the  great 
modern  railroad  of  today  through  constant  addi- 
tions, betterments  and  changes.  Yet  during  all  of 
those  years  the  owners  have  had  one  property,  a 
railroad.  They  have  never  for  a  moment  seriously 
considered  that  their  investment  consisted  of  a 
countless  number  of  units  of  property  such  as  rails 
and  ties,  bridges  and  buildings,  locomotives  and 
cars.  The  public  has  never  seriously  so  considered. 
That  property  has  grown  in  value  as  its  plant  was 
increased  and  as  its  capacity  to  render  service  in- 
creased. 

Investment  of  capital  in  any  public  utility  secures 
one  property  for  the  purpose  of  furnishing  trans- 


INVESTMENT  IN  PUBLIC  UTILITIES      15 

portation,  or  making  gas,  or  of  furnishing  electric 
power  or  for  some  other  kind  of  service. 

It  is  that  property  which  must  be  maintained  in- 
tact. It  is  that  property  which  cannot  be  confiscated. 
The  investment  once  made,  dollars  become  property. 
The  obligation  is  to  maintain  the  property. 

The  recognition  of  the  entire  plant  as  one  property 
has  been  quite  clearly  made  by  the  United  States 
Supreme  Court. 

"It  is  not  easy  to  fix  .  .  .  the  amount  of  depreciation  of  a  plant 
whose  component  parts  are  of  different  ages  with  different 
expectations  of  life"  (Knoxville  case,  212  U.  S.,  1  Jan.  4,  1909). 

"The  work  of  reconstructing  and  replacing  old  parts  by  new 
in  a  plant  of  this  kind  must,  in  the  very  nature  of  things,  be 
going  on  constantly"  (Lincoln  Gas  case,  223  U.  S.,  Feb.  19,  1912). 

"It  would  seem  to  be  inevitable  that  in  many  parts  of  the  plant 
there  should  be  such  depreciation  .  .  .  but  the  appraisement  is 
of  an  instrument  of  public  service,  as  property,  not  of  the  skill 
of  the  users.  And  when  particular  physical  items  are  estimated 
as  worth  so  much  new,  if  in  fact  they  be  depreciated  .  .  ." 
(Minnesota  Kate  cases,  230  U.  S.  p.  352,  July  9,  1913). 

"There  was  testimony  .  .  .  that  'there  may  be  depreciation  in 
the  units  composing  the  roadway  track  and  structures  of  the  rail- 
road, while  there  is  no  depreciation  in  the  machine  as  a  whole ;' " 
.  .  .  "The  testimony  .  .  .  tended  to  support  the  conclusion  .  .  . 
that  the  defendants'  railway  and  structures  were,  as  a  whole, 
maintained  throughout  the  years  in  question  in  fully  as  good 
condition  ...  as  at  the  beginning  of  the  respective  years." 
(Nashville,  Chattanooga  and  St.  Louis  vs  United  States,  269  Fed. 
351,  Dec.  7,  1920.) 

Reverting  once  more  to  the  illustration  of  the 
Michigan  Central  Railroad.  For  fifty  years  before 
anyone  commenced  to  discuss  the  subject  of  depre- 
ciation, this  company  replaced  its  ties  and  its  rail 


16      DEPRECIATION  OF  PUBLIC  UTILITIES 

as  they  needed  replacement  and  charged  the  cost 
to  operating  expenses.  Rails  declined  and  rose  in 
price,  ties  increased  in  price  many  fold,  but  the  re- 
placements were  made  of  rail,  and  of  ties,  not  of 
dollars  of  cost.  In  the  vast  majority  of  cases  no 
question  of  original  cost  of  particular  items  was 
raised  nor  was  any  change  made  in  the  capital  ac- 
counts. After  regulation  had  been  established  and 
after  accounting  classifications  were  prescribed,  the 
same  practice  was  continued.  Renewals  were  made 
and  charged  to  operating  expenses,  to  the  rate  pay- 
ers. Regulation  concerned  itself  with  seeing  to  it 
that  additions  were  not  so  charged. 

There  has  been  a  clear  distinction  made  in  recent 
accounting  that  additions  to  capital  should  include 
changes  in  quality,  size  and  capacity  of  items  of 
property.  A  replacement  of  80-lb.  rail  with  rail 
of  the  same  weight  is  an  operating  expense  pure 
and  simple,  a  replacement  with  120-lb.  rail  adds 
to  the  quality  and  capacity  and  results  in  a  better 
track  of  a  higher  type,  hence  the  40  lbs.  of  added 
weight  is  treated  as  a  capital  charge. 

The  original  25-cent  tie  on  the  old  line  of  railroad 
was  replaced  by  a  new  tie  at  40  cents,  that  in  turn 
by  one  at  70  cents,  and  that  by  one  costing  over  a 
dollar,  all  without  change  in  the  capital  account  in 
the  great  majority  of  cases. 

It  has  been  definitely  settled  that  no  money  shall 
be  placed  in  capital  accounts  on  which  dividends  are 
to  be  paid  which  is  derived  from  charges  against 
operating  expenses.^ 

^  Louisiana  Railroad  Commission  vs  Cumberland  Telephone  and  Tele- 
graph Company,  212  U.  S.  414,  on  page  423,  Feb.  23,  1909. 


INVESTMENT  IN  PUBLIC  UTILITIES      17 

It  seems  clear  that  investment  once  made  is  cap- 
ital. Capital  is  to  be  increased  as  the  property  grows 
through  additional  investment  in  new  property  or 
in  larger  property  and  is  to  be  diminished  as  dif- 
ferent parts  of  it  come  to  the  end  of  their  lives 
and  cease  to  be  of  service.  Capital  must  be  kept 
intact  by  replacements  and  so  long  as  the  entire  cost 
of  the  replacement  is  charged  to  operating  expenses 
without  any  change  in  the  capital  accounts  the  rela- 
tive cost  of  the  old  unit  and  the  new  one  replacing 
it  would  seem  to  be  wholly  immaterial. 

The  rate  payer  must  furnish  money  for  replace- 
ment or  for  reimbursing  the  owner  for  the  cost  of 
property  abandoned.  The  burden  of  securing 
proper  rates  and  of  making  proper  provision 
through  correct  accounting  is  on  the  owner,  and 
only  in  the  case  of  his  failure  to  do  this  is  there 
depreciation  in  the  sense  of  loss  of  value  to  be  de- 
ducted. 


CHAPTER  III 

THE  INTEREST  OF  THE  RATE  PAYER  IN  THE 
PROPERTY 

Owing  to  the  public  nature  of  the  utility  property, 
the  fact  that  it  is  rendering  a  service  that  might 
be  rendered  by  a  property  under  public  ownership 
and  the  fact  that  it  enjoys  rights  and  privileges 
granted  by  the  franchise,  government  has  been  defi- 
nitely held  to  have  the  right  to  regulate. 

The  people  directly  interested  are  the  investor 
and  the  consumer  or  rate  payer  in  the  case  of  the 
privately  owned  plant,  and  the  taxpayer  and  the 
rate  payer  in  the  publicly  owned  one. 

Under  either  class  of  ownership,  private  or  gov- 
ernment, the  utility  should  be  wholly  self-supporting 
and  the  payment  of  all  proper  operating  costs 
should  fall  on  the  consumer  of  the  product  through 
a  system  of  fair  and  adequate  rates. 

The  penalty  for  failure  to  exact  sufficient  rates 
falls,  in  the  one  case  on  the  general  taxpayer  in 
the  form  of  taxes  to  make  up  the  deficit  in  operation, 
a  burden  that  is  likely  to  be  very  inequitable,  and 
to  increase  greatly  the  burden  of  taxation;  in  the 
other  case  it  falls  on  the  investor  in  securities  of 
the  utility.    Whether  this  loss  fall  on  stockholders 

18 


THE   INTEREST  OF  THE   RATE   PAYER      19 

alone,  or  on  both  stockholders  and  bondholders,  the 
effect  is  to  destroy  the  financial  standing  of  the 
property,  to  make  it  difficult  or  impossible  to  find 
funds  for  needed  extensions  or  to  cause  the  collapse 
of  the  business. 

Neither  public  ownership  nor  private  ownership 
in  the  United  States  has  resulted  in  such  marked 
success  or  failure  that  either  one  can  be  pointed  to 
as  the  final  solution. 

There  have  been  many  complete  failures  under 
both  plans.  There  have  been  many  instances,  under 
both,  of  investment  in  poorly  conceived  or  ill  advised 
enterprises  which  are  operating  under  adverse  con- 
ditions and  at  a  serious  loss.  There  are,  under 
both  plans,  illustrations  of  conspicuously  good  prop- 
erties, well  managed  and  productive  of  fine  results. 
The  burden  is  on  the  management  of  the  property 
to  provide  high  enough  rates  to  meet  fully  the  re- 
quirements: Operating  expenses,  including  suffi- 
cient to  maintain  the  property  fully,  taxes,  and  in 
the  case  of  the  privately  owned  plant  a  fair  return. 
In  case  of  the  publicly  owned  plant  this  return  takes 
the  form  of  interest  on  the  bonds  which  in  most 
cases  furnish  the  entire  funds  for  construction,  and 
a  sinking  fund  to  retire  those  bonds.  The  require- 
ment of  operating  expenses  and  the  maintenance  of 
the  property  are  identical  under  both  systems  of 
ownership. 

The  writer  cannot  refrain  from  commenting,  in 
passing,  that  in  his  opinion  publicly  owned  proper- 
ties should  be  under  exactly  the  same  regulation  as 
the  privately  owned  ones,  and  would  benefit  by  that 


20      DEPRECIATION  OF  PUBLIC  UTILITIES 

regulation.  Nearly  all  of  the  so-called  publicly 
owned  properties  are  built  wholly  from  the  proceeds 
of  the  sale  of  bonds  to  private  investors.  The  bonds 
usually  carry  a  lower  rate  of  interest  than  on  a 
similar  private  utility;  but  interest  must  be  paid, 
the  borrowed  money  must  be  paid  back  and  the  plant 
must  be  maintained.  Regulation  in  the  interest  of 
the  taxpayer  and  the  investor  in  bonds  would  in 
many  cases  prove  of  inestimable  value. 

The  user  of  the  product  of  the  utility  is  the  one 
who  demands  the  service.  He  must  through  the 
rates  he  pays  furnish  the  money  which  is  essential 
in  order  that  the  service  may  be  given. 

In  any  fair  and  disinterested  consideration  of 
the  subject  it  will  have  to  be  conceded  that  the  rate 
payer's  interests  are  as  follows: 

1.  He  demands  service — ^uninterrupted  and  fully 
adequate. 

2.  To  secure  that  service  he  demands  that  the 
property  be  maintained  always  in  that  economic 
maximum  of  condition  such  that  it  can  furnish  ade- 
quate service  and  always  insure  safety.  This  in- 
volves not  only  repairs  and  current  maintenance, 
but  also  that  all  replacements  be  made  just  as  soon 
as  safety  or  other  economic  conditions  require  them 
to  be  made. 

3.  He  demands  and  is  entitled  to  rates  that  are 
fair  and  reasonable.  The  burden  should  be  equitable 
in  all  cases.  The  small  consumer  should  not  bear 
an  excessive  part  of  the  cost  in  order  that  the  large 
consumer  may  secure  service  at  a  rate  that  is  too 


THE  INTEREST  OF  THE  RATE  PAYER   21 

low.    There  must  be  nothing  approximating  the  old 
time  discrimination  or  rebating. 

4.  He  demands  that  he  be  not  required  to  pay 
excessive  rates  for  the  purpose  of  paying  a  return 
on  overstated  capital  or  watered  securities.  There 
should  be  no  attempt  on  the  other  hand  to  force  an 
under  valuation  or  to  deny  honestly  and  wisely  made 
investment  its  reasonable  return  and  guarantee  of 
integrity. 

5.  The  rate  payer  undoubtedly  has  legitimate 
ground  for  demanding  that  he  be  not  required  to 
pay  a  return  on  ill  advised  investment  or  the  ''los- 
ing venture."  These  cases,  when  they  arise,  are 
difficult  to  determine.  The  decadent  property  in 
the  small,  backward  or  slow  growing  community 
usually  requires  the  highest  of  rates  to  meet  the 
other  demands  than  return  on  investment.  No  pos- 
sible rule  can  be  laid  down  for  general  application. 
The  commission  passing  on  the  matter  must  of 
necessity  exercise  its  best  judgment.  The  matter 
is  here  referred  to  because  the  claim  is  frequently 
made,  and  not  always  properly  so,  that  properties 
are  over  developed.  There  is  a  vast  difference 
between  development  beyond  immediate  present  re- 
quirements in  a  plant  in  a  great  and  rapidly  grow- 
ing city,  where  the  business  is  showing  large  in- 
creases each  year,  or  in  a  business  of  such  char- 
acter that  the  commercial  prosperity  of  a  community 
or  district  is  largely  bound  up  in  it,  but  which  has 
not  fully  reached  its  full  load;  and  a  case  of  over 
development  in  a  plant  which  has  for  a  considerable 


22      DEPRECIATION  OF  PUBLIC  UTILITIES 

period  of  time  demonstrated  its  inability  to  earn  a 
return  on  its  investment. 

6.  The  rate  payer  is  justified  in  demanding  such. 
a  form  of  accounting  as  will  effectively  prevent  his 
being  required  to  furnish  any  money  for  enlarge- 
ment of  the  plant  through  charges  to  operating  ex- 
penses. It  is  not  the  intention  to  discuss  here  any 
question  relating  to  rate  of  return  or  any  disposi- 
tion that  may  be  made  of  surplus  funds,  the  use 
of  which  is  clearly  a  question  of  policy  of  the 
management. 

"That  it  was  right  to  raise  more  money  to  pay  for  depreciation 
than  was  actually  disbursed  for  the  particular  year  there  can  be 
no  doubt,  for  a  reserve  is  necessary  in  any  business  of  this  kind, 
and  so  it  might  accumulate,  but  to  raise  more  than  enough  money 
for  the  purpose  and  place  the  balance  to  the  credit  of  capital 
upon  which  to  pay  dividends  cannot  be  proper  treatment," 
{Louisiana  Railroad  Commission  vs  Cumberland  Telephone  and 
Telegraph  Company,  212  U.  S.  414,  Feb.,  1909.) 

7.  It  is  not  a  matter  of  concern  to  the  rate  payer 
how  the  management  treats  the  accounting  for  re- 
placement of  property  so  long  as  the  amounts  raised 
for  this  purpose  are  enough  to  maintain  fully  the 
property  to  such  a  condition  as  is  economically  wise, 
but  are  not  excessive  enough  to  include  charges  for 
construction,  addition  or  betterment.  It  may  be  the 
decision  of  the  regulating  commission  or  the  policy 
of  the  management  to  do  this  either  through  direct 
charges  of  replacements  to  operating  expenses,  or 
by  the  creation  of  reserves  for  replacement  or  de- 
preciation, or  by  the  use  of  one  method  for  parts 


THE  INTEREST  OF  THE  RATE  PAYER   23 

of  the  property  and  the  other  method  for  other 
parts. 

"The  Railroad  Company  may,  if  it  sees  fit,  anticipate  general 
depreciation,  and  make  provision  for  them  by  establishing  a 
reserve  for  that  purpose;  but  if  no  such  iDrovision  has  been  made 
the  abandonments  should  be  taken  care  of  by  charging  them  to 
present  or  future  operating  expenses."  {Kansas  City  Southern 
Railway  Co.  vs  United  States,  231  U.  S.  423,  Dec.  1,  1913.) 

8.  The  rate  payer  is  interested  in  knowing  that 
he  is  not  being  charged  an  excessive  amount  for 
depreciation  either  through  a  duplication  of  charges 
such  as  happens  when  replacements  are  charged  to 
operating  expenses  at  the  same  time  that  reserves 
are  being  built  up,  or  through  excessive  charges  to 
depreciation  on  account  of  obsolescence  which  is 
chargeable  to  future  rate  payers  because  of  the  econ- 
omies which  are  secured  by  the  new  type  of 
property. 

"No  such  carrier  shall  in  any  case  include  in  any  form  under 
its  operating  or  other  expenses  any  depreciation  or  other  charge 
or  expenditure  included  elsewhere  as  a  depreciation  charge  or 
otherwise  under  its  operating  or  other  expenses."  ( Sec.  20,  par.  5, 
Interstate  Commerce  Act  as  amended.) 

"Abandonments  occasioned  by  changes  of  this  character  are 
therefore  chargeable  to  future  earnings."  {Kansas  City  Southern 
Railway  Company  vs  United  States,  231  U.  S.  423,  451,  452.) 

In  summarizing  it  may  be  said  that  the  rate  payer, 
the  user  of  the  service,  is  the  one  who  must  support 
the  enterprise.  His  need  for  the  service  resulted  in 
the  granting  of  a  franchise  and  the  building  of  a 


24      DEPRECIATION  OF  PUBLIC  UTILITIES 

plant.  The  character  of  the  service  is  such  that  free 
competition  cannot  be  depended  upon  to  regulate 
price  or  quality  of  service,  hence  we  have  gradually 
come  to  regulation  by  governmental  authority.  The 
rate  payer  or  consumer  is  primarily  interested  in 
service.  To  get  that  service  he  must  pay  a  return 
sufficient  to  attract  money  to  the  business.  The 
return  on  the  investment,  the  fair  return  on  the 
*'fair  value,"  is  the  incentive  for  building  the  plant 
and  giving  the  service.  When  such  a  return  is  re- 
fused, money  cannot  be  had  for  the  business. 

Just  as  long  as  the  consumer  who  pays  gets  ade- 
quate service  at  reasonable  and  proper  rates  and  is 
not  compelled  to  pay  charges  which  will  support  an 
ill  advised  investment,  or  fictitious  capital  or  per- 
mit excessive  charges  to  depreciation  or  improper 
charges  to  capital  as  part  of  the  requirement  made 
of  him,  he  has  no  just  ground  for  complaint. 

It  must  be  a  mutual  arrangement.  Each  party 
must  know  and  respect  the  rights  of  the  other. 
Failure  to  do  this  in  the  past  has  resulted  in  govern- 
ment regulation. 


CHAPTER  IV 

OPERATING  EXPENSES 

When  a  property  of  any  kind  is  built,  and  after 
operation  is  commenced,  every  item  of  cost  which  is 
chargeable  to  production  is  an  operating  expense. 

For  a  long  period  of  time,  before  the  regulation 
of  utilities,  there  was  an  evident  failure  to  recognize 
a  clear  line  of  demarcation  between  capital  costs  and 
operating  costs.  This  is  manifest  in  some  of  the 
older  decisions  of  the  courts. 

Even  at  present  many  owners  and  managers  of 
property  are  misleading  themselves  and  their  stock- 
holders by  a  failure  to  recognize  the  fundamental 
fact  that  there  can  be  no  real  net  earnings  until 
every  element  of  cost  of  operating  expense,  which 
properly  speaking  is  the  total  cost  of  rendering 
service,  is  accounted  for  and  deducted  from  gross 
income  from  operations.  Failure  to  do  this  cor- 
rectly results  in  over  statement  of  net  earnings. 

These  misconceptions  are  probably  largely  ex- 
plained by  the  fact  that  the  calendar  year  is  the 
fiscal  unit  used  in  accounting.  It  is  easy  to  under- 
stand that  money  paid  out  for  the  labor  of  operating 
a  plant,  or  the  money  paid  out  for  coal,  oil  and  other 
consumable  supplies  used  in  operation  during  any 

25 


26      DEPRECIATION  OF  PUBLIC  UTILITIES 

fiscal  year  are  operating  expenses  belonging  to  that 
year.  In  the  same  way  it  is  not  hard  to  understand 
that  replacement  of  short  lived  parts  of  the  plant, 
which  are  renewed  within  the  year  are  operating 
expenses. 

It  has  been  much  more  difficult  to  grasp  the  idea 
that  the  wearing  out  of  consumable  property,  which 
has  a  life  of  two,  three,  five  or  more  years,  and  which 
must  necessarily  be  replaced  in  order  that  service 
may  be  continuous,  is  just  as  much  a  part  of  the 
cost  of  service  as  the  labor  or  the  coal. 

Any  replacement  of  property  units  used  in  opera- 
tion, be  the  units  large  or  small,  which  does  not 
change  the  character  of  the  property,  or  increase 
its  size  or  capacity,  is  an  operating  expense,  no 
matter  how  long  the  life  of  the  unit  may  be.  Two 
or  three  illustrations  may  make  this  clear. 

In  the  operation  of  a  gas  plant  in  a  large  city  the 
lining  of  the  retorts  needs  renewal  every  three  or 
four  years  while  the  retorts  themselves  will  last 
fifteen  or  twenty  years.  The  cost  of  relining  the 
retorts  is  a  part  of  the  labor  and  consumable  ma- 
terial connected  with  the  making  of  gas,  and  is 
generally  charged  directly  to  operating  expense. 
The  cost  of  replacing  the  retorts  is  just  as  much  a 
charge  against  the  cost  of  gas  although  less  evident. 
In  a  large  plant  the  relining  of  some  of  the  retorts 
takes  place  every  year,  so  that  a  direct  charge  to 
operating  expenses  for  the  work  done  each  year 
will  not  cause  any  material  variation  in  the  total 
amount  of  money  charged  to  operating  expenses  in 
any  one  year  over  the  others. 


OPERATING  EXPENSES  27 

Another  illustration  is  the  railroad  track  on  the 
line  from  Detroit  to  Chicago.  The  life  of  the  ties 
is  from  eight  to  ten  years,  that  of  rail  and  fasten- 
ings under  existing  conditions  of  traffic  from  six 
to  eight  years,  and  all  other  elements  of  the  track 
have  a  varying  life  of  a  few  years.  As  the  railroad 
is  seventy-five  years  old,  there  have  been  five  or  six 
renewals  of  rail,  ties  and  other  items. 

Except  as  there  have  been  changes  in  weight  of 
rail  and  other  material,  or  as  new  property  such 
as  second  track  or  block  signals  have  been  added, 
there  has  been  no  increase  in  the  property.  The 
same  length  of  line  is  operated  as  at  first.  The  ad- 
ditions make  possible  greater  capacity  for  service. 
The  rails  have  worn  out  in  the  furnishing  of  trans- 
portation in  just  the  same  way  that  the  coal  was 
burned  in  the  locomotive  in  the  furnishing  of  trans- 
portation. 

A  third  illustration  is  the  waterworks.  Such  a 
plant  consists  of  a  few  large  and  long  lived  units 
of  property.  When  a  ten  million  gallon  pump  is 
replaced  by  another  one  the  cost  of  the  replaced 
pump  can  only  be  charged  to  the  service  of  pump- 
ing water,  and  each  million  gallons  pumped  is 
properly  chargeable  with  its  proportion  of  the  cost 
of  the  pump  as  an  operating  expense.  The  new 
pump,  if  of  the  same  capacity  as  the  old  one  adds 
nothing  to  the  capacity  of  the  property  nor  to  its 
value. 

For  accounting  purposes  this  class  of  operating 
expenses,  replacement  of  units  or  items  of  property, 
group  themselves  into  two  distinct  classes. 


28      DEPRECIATION   OF  PUBLIC   UTILITIES 

First,  those  which  can  be  charged  directly  to 
operating  expenses  when  the  renewal  is  made  with- 
out causing  any  material  change  or  fluctuation  of 
the  ratio  of  operating  expenses  to  gross  earnings 
from  operation ;  and, 

Second,  those  which  cannot  be  so  charged  without 
a  violent  fluctuation  of  the  operating  ratio. 

Referring  to  the  illustrations,  it  is  evident  that 
on  a  large  property,  replacements  become  fairly 
well  distributed  and  do  not  recur  at  one  period. 
Thus  the  lining  of  the  gas  retorts  or  the  replacement 
of  rail  and  ties  will  be  in  fairly  uniform  amount 
year  after  year  on  a  large  property.  Direct  charges 
of  such  replacements  to  operating  expense  will 
create  no  violent  fluctuation  and  the  property  may 
be  kept  in  good  operating  condition  indefinitely  with- 
out the  establishment  of  any  reserves.  What  is  true 
of  the  large  gas  plant  or  the  large  railroad  may  not 
turn  out  to  be  the  same  on  the  small  one.  The 
tendency  on  the  part  of  officers  of  corporations  to 
hold  otf  the  making  of  expenditures  during  a  period 
of  business  depression  is  likely  to  cause  the  largest 
variation  in  operating  expense  in  a  property  which 
can  be  maintained  through  direct  charges  to  oper- 
ating expense.  On  the  other  hand  the  waterworks, 
having  at  most  four  or  five  pumps,  one  or  two  res- 
ervoirs, one  or  two  standpipes  and  a  system  of  iron 
pipes  underground,  constitutes  an  excellent  example 
of  a  property  on  which  renewals  are  not  uniform, 
but  which  faces  violent  fluctuations  of  the  operating 
ratio  whenever  major  renewals  do  occur. 

It  is  therefore  not  strange  that  it  was  the  water- 


OPERATING  EXPENSES  29 

works  industry  which  first  developed  the  plan  of 
setting  aside  a  reserve  each  year  to  offset  the  wear 
and  tear  and  aging  of  that  year.  The  waterworks 
men  first  used  the  term  ''depreciation,"  in  the  sense 
that  provision  must  be  made  to  overcome  the  gradual 
wearing  out  of  large  units  of  property,  so  reserves 
were  created  for  the  purpose  of  making  replace- 
ments. 

It  is  unfortunate  that  this  meaning  has  been  given 
to  the  word  depreciation.  While  the  use  in  the  case 
of  the  waterworks  is  perhaps  more  fully  descriptive 
than  any  other  term,  the  fact  remains  that  there  is 
another  use  of  the  word  depreciation  in  public  util- 
ity regulation  practice,  in  which  it  has  been  given 
a  distinctly  different  meaning. 

Inasmuch  as  the  primary  meaning  of  the  word  is 
loss  of  value,  and  as  the  second  use  of  the  word  has 
direct  reference  to  that  loss  of  value,  in  utility  prop- 
erties, which  should  be  deducted  in  finding  a  base 
for  rate  making,  it  would  seem  that  the  use  of  the 
word  might  advantageously  be  dropped  in  account- 
ing practice,  and  the  terms  Reserve  for  Replacement 
and  Allowance  for  Replacement  used  instead.  It  has 
also  been  suggested  that  the  word  retire  be  used 
instead  of  replace.  Inasmuch  as  some  of  the  State 
Utility  Commission  accounting  circulars  have  al- 
ready adopted  the  term  replacement  instead  of  ''de- 
preciation" this  practice  is  advocated,  although 
either  word,  replace  or  retire,  would  be  proper,  and 
correctly  describe  the  thing  that  takes  place  in  a 
continuing  property. 

Where  the  retirement  is  not  accompanied  by  re- 


30      DEPRECIATION  OF  PUBLIC  UTILITIES 

placement  as  happens  when  a  piece  of  property  is 
abandoned  and  the  service  discontinued,  there  is 
real  justification  for  the  use  of  the  term  deprecia- 
tion. 

Much  of  the  misunderstanding  regarding  the  sub- 
jects of  depreciation  and  replacement  of  property 
and  of  accounting  methods  for  overcoming  the  de- 
terioration due  to  different  causes  is  undoubtedly 
due  to  the  confusing  use  of  the  word  *' deprecia- 
tion." It  has  been  given  different  meanings  and 
shades  of  meaning  and  has  been  compounded  with 
other  words  until  a  perfect  maze  of  confusing  jargon 
has  been  put  forward  in  the  attempt  to  clarify  the 
subject.  One  of  the  first  things  that  needs  to  be 
done  is  to  clear  away  a  tangle  of  words  and  terms. 
If  one  of  the  meetings  of  the  members  of  the  dif- 
ferent regulating  commissions  of  the  United  States 
would  devote  a  session  to  this  subject  and  would 
agree  upon  a  few  simple  terms  with  definitions  it 
would  be  a  real  service. 

The  accounting  practice  of  many  years  has  rec- 
ognized the  propriety  of  charging  replacements 
directly  to  operating  expense  accounts,  especially  in 
the  case  of  such  items  as  rails,  ties,  track  structures, 
poles,  overhead  lines  and  other  structures  where 
great  numbers  of  units  exist  on  one  property. 

While  the  creating  of  reserves  for  replacement  is 
of  comparatively  recent  origin,  as  has  been  pointed 
out,  it  has  had  the  approval  of  courts  and  commis- 
sions, and  has  been  strongly  urged  by  many  utilities. 
In  recent  months  there  has  been  a  tendency  to  note 
some  danger  in  the  practice.     Like  many  another 


OPERATING  EXPENSES  31 

good  tiling,  it  is  not  only  capable  of  abuse,  but  it  is 
undoubtedly  being  abused. 

The  Interstate  Commerce  Commission  recognizes 
and  prescribes  both  methods  in  its  accounting  class- 
ifications. The  Supreme  Court  of  the  United  States 
in  its  decisions  has  recognized  both  methods  and 
has  distinctly  held  that  the  replacement  of  property 
was  a  proper  charge  against  the  rate  payer. 

There  should  be  considerable  latitude  left  to  the 
management  of  the  corporation  in  the  matter  of 
selection  of  accounting  methods,  as  there  is  such 
great  diversity  of  conditions  on  different  properties. 
Identical  units  of  property  owned  by  one  corpora- 
tion may  be  charged  by  the  replacement  method, 
owing  to  a  large  number  of  such  units,  while  another 
corporation  having  but  a  few  units  may  find  that 
the  replacement  method  is  not  nearly  so  desirable 
as  it  is  to  create  reserves  and  spread  the  charge  to 
operating  expenses  over  a  longer  period. 

One  question  which  is  open  to  debate  in  connec- 
tion with  the  subject  of  replacements  as  operating 
expenses,  is  whether  the  charge  should  be  of  the 
cost  of  the  original  unit,  any  excess  cost  being 
charged  to  capital,  or  whether  the  cost  of  the  new 
unit  should  be  directly  charged  to  operating  ex- 
penses without  any  readjustment  of  the  capital 
accounts. 

Regardless  of  the  accounting  method  which  may 
be  adopted,  the  fundamental  truth  that  must  be  rec- 
ognized by  everyone  is  that  the  cost  of  maintaining 
the  property  and  replacing  all  parts  of  it  as  those 
parts  wear  out,  is  an  operating  expense,  a  cost  of 


32      DEPRECIATION  OF  PUBLIC  UTILITIES 

rendering  service.  Unless  it  is  so  recognized  and 
accounted  for,  earnings  will  be  overstated,  and  the 
property  will  not  be  kept  intact. 

It  must  also  be  kept  in  mind  that  the  chief  reason 
for  the  insistence  upon  reserves  for  replacement  is, 
not  the  benefiting  of  the  company,  but  the  protec- 
tion of  the  patrons  of  the  company  by  insuring  con- 
tinuity of  service  and  providing  means  to  enable  the 
company  to  make  the  necessary  replacements  as 
they  become  due. 


CHAPTER  V 
WAR  PERIOD  PRICE  FLUCTUATIONS 

Commencing  in  1914  with  the  beginning  of  the 
war  in  Europe  prices  of  commodities  of  all  kinds 
and  of  labor  rapidly  increased,  reaching  the  maxi- 
mum late  in  1920,  Prices  dropped  to  a  considerably- 
lower  level  in  1921  than  prevailed  in  1920 ;  but  they 
are  still  far  above  pre-war  prices,  indeed  are  well 
above  the  level  that  prevailed  during  the  early  years 
of  the  war  in  Europe. 

This  increase  of  costs  materially  affected  the 
utilities  which  were  operating  under  conditions  of 
price  regulation,  especially  those  whose  rates  were 
fixed  by  contract. 

These  price  fluctuations  came  Just  at  a  time  when 
the  practice  of  valuation  was  becoming  reasonably 
stablized  and  rules  and  methods  of  valuation  were 
being  formulated  and  quite  generally  accepted  and 
followed  by  the  engineering  profession.  The  most 
complete  statement  of  principles  and  methods  of 
valuation  which  has  ever  been  published  is  the  final 
report  of  the  Special  Committee  of  the  American 
Society  of  Civil  Engineers,  presented  on  Jan.  17, 
1917  and  published  in  Vol.  81  of  the  T ransactio'}is 
of  that  society. 

33 


34      DEPRECIATION   OF   PUBLIC   UTILITIES 

That  report  was  prepared  during  the  years  1913 
to  1917,  at  a  time  when  price  fluctuations  caused 
by  the  war  in  Europe  had  hardly  begun  to  be  felt 
in  the  United  States,  and  before  the  entrance  of  this 
country  into  the  war  was  imminent.  The  conclu- 
sions of  this  committee  as  to  proper  prices  to  use 
in  making  an  estimate  of  the  cost  of  reproduction 
are  found  on  page  1372  of  the  report  and  are  as 
follows : 

"The  Committee  believes  that  the  foregoing  decisions  require 
the  use  of  present  rather  than  original  prices  in  estimating  repro- 
duction cost.  It  recognizes,  however,  that  undesirable  fluctuations 
in  the  estimated  value  of  property  valued  at  intervals  would  occur 
owing  to  changes  in  prices.  It  suggests  that  this  may  be  avoided 
and  the  value  from  year  to  year  of  a  property  which  has  been 
once  properly  valued  may  be  determined  if  proper  methods  of 
accounting  are  adopted. 

"In  the  case  of  a  new  or  recently  created  property,  which  has 
had  from  the  beginning,  under  continuous  and  proper  regulation 
a  modern  system  of  accounting,  which  has  taken  account  of  all 
proper  capital  charges  and  credits,  so  that  the  amount  of  invested 
capital  would  be  known  at  all  times,  such  invested  capital  would 
be  entitled  to  greater  weight  on  equitable  grounds  as  an  indica- 
tion of  the  so-called  'fair  value'  than  an  estimate  of  cost  of 
reproduction  less  depreciation  which  might  involve  radical 
changes  of  prices;  but  we  are  not  now  discussing  original  cost 
to  date,  nor  what  is  the  proper  basis  for  'fair  value.'  For 
reproduction  cost  the  Committee  recommends  that,  in  estimating, 
the  prices  prevailing  at  the  assumed  time  of  reproduction  shall  be 
used,  meaning  the  normal  prices  obtained  by  averaging  prices  for 
a  proper  period,  as  is  fully  discussed  subsequently  in  this  chapter 
under  the  caption  'Unit  Prices.'  " 

The  caption  referred  to  is  entitled  "Shall  Aver- 
age Prices,  or  Prices  as  of  a  Certain  Date  be  Used?" 


WAR  PRICE  FLUCTUATIONS  35 

On  page  1383  the  following  conclusions  of  the  Com- 
mittee are  given: 

"The  practice,  adopted  on  some  recent  appraisals,  of  using  a 
price  derived  from  a  weighted  average  of  actual  purchases  over 
a  period  of  from  five  to  ten  years  on  the  property  under  investi- 
gation, has  the  merit  of  using  actual  investment  in  recent  years 
as  a  basis  for  determining  a  unit  to  be  used  on  the  entire  prop- 
erty, and  meets  the  objection  raised  by  the  Second  District  Com- 
mission of  New  York. 

"Present-day  labor  prices  can  be  determined  by  an  analysis  of 
pay-rolls  over  such  a  length  of  time  as  will  give  proper  actual 
averages  for  each  class  of  labor.  By  a  comi3arison  with  similar 
data  derived  from  records  of  other  properties  in  the  immediate 
vicinity,  prices  may  be  derived  which  are  actual  and  are  capable 
of  proof.  Prices  thus  determined  would  seem  to  be  proper  bases 
on  which  to  build  up  estimates  of  total  labor  entering  into  the 
various  units. 

"Any  price  which  is  used  must  be  a  matter  of  judgment,  in  the 
light  of  all  available  facts,  but  the  arbitraiy  selection  of  a  cer- 
tain specific  date  as  the  date  of  appraisal  does  not  seem  to  justify 
the  use  of  prices  which  are  abnormal.  However  derived,  the 
prices  used  for  fluctuating  materials  should  be  proper  for  the 
estimated  period  of  reproduction  which  should  end  with  the  date 
as  of  which  the  investigation  is  made,  and  which  should  be  suf- 
ficiently stable  so  that  no  reappraisal  within  a  short  time  there- 
after should  make  violent  changes  in  estimates  of  reproduction 
cost." 

At  the  time  of  the  drafting  of  this  report  (1916 
and  prior  years),  it  was  contended,  and  the  conten- 
tion had  the  full  approval  of  the  courts,  that  in  the 
absence  of  records  of  actual  cost,  the  cost  of  repro- 
duction method  of  valuation  was  a  proper  method, 
and  gave  the  most  reasonable  basis  for  fixing  fair 
value  when  actual  investment  was  not  ascertainable. 


36      DEPRECIATION  OF  PUBLIC  UTILITIES 

The  Cost  of  Eeproduction  method  was  first  used, 
and  the  name  was  first  applied  in  large  valuation 
work,  on  the  Michigan  Eailroad  valuation  of  1900, 
by  Professor  M.  E.  Cooley.  This  was  the  first 
state  wide  valuation  to  be  made.  Prior  to  1900 
there  had  been  a  small  amount  of  railroad  valuation 
work  in  Texas  and  a  few  waterworks  valuations 
throughout  the  country,  but  no  recognized  stand- 
ards had  been  created  for  doing  such  work.  Pro- 
fessor Cooley  first  advanced  the  reproduction  theory, 
under  that  name,  as  a  rational  plan  for  determining 
value  in  the  case  of  a  large  number  of  old  properties 
whose  original  cost  could  not  be  ascertained,  many 
of  them  had  very  incomplete  records  of  property.  It 
must  be  remembered  that  this  pioneer  work  was 
done  seven  years  before  the  passage  of  the  law  re- 
quiring uniform  accounting  and  before  any  of  our 
state  commissions  had  undertaken  to  regulate  ac- 
counting.^ 

This  method  was  adopted  and  amplified  in  the 
making  of  many  subsequent  valuations  and  the  de- 
velopment of  fifteen  years'  practice  is  fully  set  forth 
in  the  report  of  the  American  Society  of  Civil  En- 
gineers Committee.  It  will  be  particularly  noticed 
that  the  recent  contention  for  the  use  of  extreme  high 
or  low  prices  as  of  a  given  date  had  not  appeared 
at  all  in  1916  (at  the  time  when  the  final  report  of 
the  Committee  was  drafted)  and  that  the  committee 
argued  for  the  adoption  of  average  prices  applicable 

*  For  description  of  this  work  see  "The  Valuation  of  Public  Service 
Corporation  Property,"  by  Henry  E.  Riggs,  Tvam^  Am.  Soc.  C.  E., 
vol.  72  (1911). 


WAR  PRICE  FLUCTUATIONS  37 

at  the  time  of  the  making  of  the  valuation.  The 
Cooley  1900  appraisal  used  a  five-year  average,  and 
nearly  all  appraisers  up  to  the  year  1917  aimed  to 
secure  unit  prices  that  did  not  reflect  abnormal 
market  conditions  but  which  did  fairly  reflect  in- 
vestment cost  of  the  property. 

Commencing  with  the  sharp  increase  of  prices  in 
1917,  the  utilities  faced  the  worst  crisis  of  their 
history.  Rates  were  fixed  in  most  cases  by  the 
authority  of  some  Regulating  Commission  or  by 
contract,  and  the  rapid  rise  in  operating  costs  which 
took  place  between  1916  and  1920  forced  many  of 
the  companies  to  the  verge  of  bankruptcy. 

The  courts  and  regulating  commissions  promptly 
took  the  ground  that  increased  operating  expenses 
due  to  the  abnormal  condition  must  be  allowed.  The 
contention  was  strongly  urged  by  some  of  the  com- 
panies that  earlier  court  decisions,  prior  to  Jan. 
1,  1917,  sustained  the  use  of  the  reproduction  theory 
in  all  cases,  and  that  prices  as  of  the  date  of  the 
inquiry  were  the  proper  prices  to  use.  This  would 
of  course  result  in  higher  figures  of  "fair  value"  on 
which  the  return  would  be  based.  It  is  to  be  noted 
that  this  new  construction  was  first  suggested  in 
cases  coming  up  for  hearing  in  1917,  1918  and  1919. 

As  the  writer  has  always  construed  the  earlier 
decisions  of  the  courts,  and  as  he  recalls  the  details 
of  his  own  practice,  and  the  discussions  of  the  Amer- 
ican Society  of  Civil  Engineers'  Committee,  he  feels 
justified  in  stating  that  the  courts  accepted  the  Cost 
of  Reproduction  method  with  reservation.  The 
writer  knows  of  no  cases  prior  to  the  war  in  which 

4790  5 


38      DEPRECIATION   OF   PUBLIC   UTILITIES 

the  contention  was  made  by  reputable  engineers,  or 
sustained  by  court  or  commission  that  extreme 
maximum  or  extreme  minimum  prices  as  of  a  given 
date  were  proper  to  use  in  a  valuation  unless  it  were 
shown  that  there  was  actual  investment  in  property 
at  such  prices. 

The  contention,  that  early  court  decisions  to  the 
effect  that  the  value  to  be  found  should  be  as  of  the 
date  of  the  investigation,  '*at  the  time  of  inquiry," 
means  the  use  of  prices  as  of  a  certain  day,  which 
may  be  100  per  cent  in  excess  of  actual  investment, 
or  less  than  actual  investment,  is  a  new  contention 
first  advanced  by  the  utilities  when  facing  the  stress 
of  war-time  conditions. 

The  adoption  of  this  plan  resulted  in  greatly  in- 
creased valuations  from  1917  to  1921,  especially  in 
1919  and  1920,  but  the  results  are  far  from  uniform 
and  tend  to  give  the  greatest  increases  over  actual 
investment  to  the  older  properties,  and  to  those 
doing  but  a  small  amount  of  extension  during  the 
period  of  high  prices.  This  is  well  illustrated  in 
the  case  of  two  large  electric  light  and  power  prop- 
erties in  two  large  cities. 

One,  a  strong  company  wdth  a  large  and  rapidly 
growing  business,  was  called  upon  to  meet  the  de- 
mands of  industry  during  the  war  period  by  making 
extensions  and  additions  at  more  than  double  the 
rate  of  pre-war  construction.  During  the  four  years 
1917  to  1920  inclusive  its  new  extensions  have  cost 
several  millions  of  dollars  per  year  amounting  to  a 
total  almost  as  large  as  the  valuation  of  its  entire 
property  made  in  1915. 


WAR  PRICE  FLUCTUATIONS  39 

The  other  property  located  in  a  city  of  several 
hundred  thousand  population  had  a  plant  built  prior 
to  the  war,  with  a  power  station  which  was  com- 
menced prior  to  1900  and  completed  in  its  present 
form  in  1915  or  1916.  The  increase  in  business  dur- 
ing the  war  period,  which  has  not  proven  permanent, 
was  taken  care  of  by  purchased  power,  so  that  the 
new  construction  consisted  wholly  of  transmission 
and  distribution  lines,  and  aggregated  less  than  one 
million  dollars  or  about  one-tenth  of  the  figure  that 
a  pre-war  valuation  would  have  shown. 

In  the  one  case  a  valuation  in  1920  using  July,  1920 
prices  would  have  shown  an  increase  of  from  50 
per  cent  to  60  per  cent  above  the  actual  investment 
while  in  the  other  case  of  the  less  valuable  property 
it  would  have  shown  an  increase  of  over  100  per 
cent  above  the  investment. 

If  prices  should  drop  to  the  pre-war  level  in  the 
next  few  years,  and  a  revaluation  of  the  identical 
properties  are  made  at  that  time,  the  better  property 
will  have  a  reproduction  cost  25  per  cent  less  than 
investment,  while  the  less  valuable  one  will  approxi- 
mately equal  the  investment. 

Public  Utility  Commissions  have  been  faced  dur- 
ing the  past  few  years  for  the  first  time  since  their 
establishment  with  the  problem  of  making  rates  and 
determining  values  during  a  period  of  greatly  un- 
settled prices. 

No  one  can  predict  with  any  degree  of  certainty 
just  what  conditions  will  prevail  at  any  fixed  time 
in  the  future.  The  records  of  price  fluctuations  of 
the  past  are  something  of  a  guide,  but  we  cannot 


40      DEPRECIATION  OF  PUBLIC  UTILITIES 

base  forecasts  on  the  curves  of  prices  of  the  Civil 
War  period  with  any  certainty  on  account  of  rad- 
ically different  conditions  existing  today  from  any 
which  have  ever  existed  before.  The  Great  War 
differs  from  the  Civil  War  in  that  the  whole  world 
was  involved,  while  from  1860  to  1865  only  the 
United  States  was  affected.  This  is  shown  clearly 
by  a  study  of  price  curves  of  the  United  States, 
England,  France  and  other  countries.  The  Amer- 
ican  Civil  War  hardly  affected  European  prices. 

The  great  loss  of  capital  and  of  man  power,  espe- 
cially in  Europe  is  bound  to  have  its  effect  for  a 
long  number  of  years. 

The  prices  of  October,  1920  stood  at  225  per  cent 
of  1913.  By  February,  1920  they  had  fallen  to  160 
per  cent  and  for  the  entire  year  1921  have  been  at 
a  still  lower  figure.  We  may  expect  considerable 
fluctuations  in  the  curve  but  we  are  fully  justified 
in  looking  for  a  general  tendency  of  prices  down- 
ward. It  took  over  twenty  years  for  prices  after 
the  Civil  War  to  return  to  the  level  which  prevailed 
before  the  war. 

It  is  not  amiss  to  estimate  that  it  will  take  a  term 
of  years,  but  the  estimate  must  be  modified  by  tak- 
ing into  account  the  fact  that  the  United  States  of 
today  is  not  at  all  comparable  with  the  United 
States  of  1865.  Our  wealth  today  is  so  great  and 
our  commerce,  manufacturing  and  agriculture  are 
so  well  established  as  not  to  be  comparable  with 
conditions  at  the  close  of  the  Civil  War  when  we 
had  just  come  through  four  years  of  war  at  home 
and  when  the  southern  states  had  been  so  wrecked 


WAR  PRICE  FLUCTUATIONS  41 

that  it  has  required  half  a  century  for  them  to  build 
up  to  approximately  the  same  condition  as  to  wealth 
as  existed  in  1860. 

As  far  as  we  ourselves  are  concerned  we  might 
expect  a  quick  return  to  normal  were  it  not  for 
the  condition  of  European  nations.  There  are  so 
many  factors  which  will  affect  trade  conditions  and 
prices  that  the  business  of  long  range  prophecy  is 
risky  in  the  extreme.  It  is  hardly  to  be  presumed 
-that  courts  and  regulating  commissions  will  indulge 
in  much  of  this  sort  of  thing. 

The  effect  of  the  changes  in  price  level  has  been 
to  give  rise  to  two  opposing  theories  concerning 
the  proper  basis  upon  which  to  fix  rates. 

One  insists  that  rates  shall  be  adequate  to  pay 
operating  expenses,  depreciation  and  a  fair  return 
on  the  investment  which  the  property  represents. 

The  other  theory  insists  that  the  "fair  value"  of 
the  property  at  the  time  the  rates  are  in  question 
shall  be  the  basis  of  rates.  If  that  value  is  less  than 
the  investment  the  loss  shall  be  borne  by  the  owner 
of  the  property,  if  it  be  greater  than  the  investment 
the  owner  shall  enjoy  the  advantages  of  the  enhance- 
ment in  value.  This  theory  makes  cost  of  repro- 
duction as  of  a  given  date  synonymous  with  ''fair 
value. ' ' 

One  theory  argues  that  the  rates  of  return  shall 
be  variable,  rising  or  falling  to  meet  the  varying 
conditions  prevailing  in  the  business  world,  the  other 
contends  that  the  value  should  be  variable. 

This  is  a  statement  of  the  theories  as  they  must 
be  analysed.    It  would  appear  that  some  have  con- 


42      DEPRECIATION   OF   PUBLIC   UTILITIES 

tended  for  the  theory  of  fluctuating  value  at  a  time 
when  it  would  most  benefit  themselves,  and  have 
at  the  same  time  argued  the  condition  of  the  money 
market  in  support  of  a  claim  for  increased  rates  of 
return. 

The  most  marked  effect  of  the  change  of  price 
levels  has  been  to  increase  labor  and  material  costs 
of  both  operating  expenses  and  construction  to  a 
point  approximately  double  the  costs  of  pre-war 
years  during  the  years  1919  and  1920,  the  period 
during  which  there  was  much  activity  in  rate  regu- 
lation, and  a  number  of  cases  reached  the  courts. 

The  questions  to  be  answered,  therefore,  may  be 
stated  as  follows: 

First.  In  valuation  shall  prices  as  of  any  given 
date,  or  prices  averaged  over  a  term  of  years  be 
used?    Or  shall  investment  be  accepted? 

Second.  Shall  reproduction  be  accepted  as  the 
basis,  even  in  cases  where  actual  investment  is 
capable  of  determination? 

Third.  If  the  actual  operating  costs  are  recog- 
nized, as  they  properly  have  been,  is  there  justifica- 
tion for  increasing  capital  values  on  account  of  high 
costs  of  reproduction  even  in  cases  where  there  has 
been  no  investment  at  such  figures? 

Fourth.  In  case  of  replacement  of  property  at 
prices  greatly  in  excess  of  the  original  cost  of  the 
property  which  is  retired,  shall  the  entire  cost  of 
the  replacement  be  considered  as  an  operating  ex- 
pense, or  shall  the  excess  cost  of  the  new  thing  over 
the  old  be  capitalized? 


CHAPTER  VI 
FAIR  VALUE  AND  THE  RATE  OF  RETURN 

The  whole  development  of  valuation  of  public 
utility  properties  is  based  on  the  decisions  of  the 
United  States  Supreme  Court  holding  that  there 
must  be  a  fair  return  on  ''Fair  Value." 

"The  fair  value  of  the  property  being  used  by  it  for  the  con- 
venience of  the  public."  "What  the  company  is  entitled  to  ask 
is  a  fair  return  on  the  value  of  that  which  it  employs  for  the 
public  convenience."  {Smyth  vs  Ames,  169  U.  S.  466,  March  7, 
1898,  p.  546.) 

"The  fair  value  of  its  property  devoted  to  the  public  use." 
"The  value  of  its  property  actually  used  for  the  public."  {Will- 
cox  vs  Consolidated  Gas  Company,  212  U.  S.  19,  Jan.  4,  1909, 
p.  50.) 

"The  basis  of  calculation  is  the  fair  value  of  the  property 
used  for  the  convenience  of  the  public"  (Minnesota  Rate  Cases; 
Simpson  et  al  vs  Shepherd,  230  U.  S.  352,  June  9,  1913,  p.  434). 

As  has  been  brought  out,  valuation  practice 
was  developed  during  the  period  covered  by  the 
above  quoted  decisions.  The  cost  of  reproduction 
was  evolved  to  meet  a  condition  which  made  some- 
thing of  the  sort  necessary,  but  the  consensus  of 
engineering  opinion  before  the  war  was  that  actual 
investment  on  recently-built  properties  formed  the 

43 


44      DEPRECIATION  OF  PUBLIC  UTILITIES 

best  possible  basis  for  determining  "fair  value." 
The  better  accounting  methods  of  the  past  twelve  or 
fifteen  years  have  gone  far  to  eliminate  the  con- 
ditions which  made  necessary  the  early  use  of  the 
Cost  of  Reproduction  method,  and  as  far  as  newly 
built  properties,  additions,  and  replacements  are 
concerned  actual  investment  can  be  determined  in 
most  cases. 

It  must  be  here  again  emphasized  that  up  to  1913 
the  courts  accepted  cost  of  reproduction,  in  the  ab- 
sence of  a  better  basis,  but  with  reservations. 

"The  cost  of  reproduction  method  is  of  service  in  ascertaining 
the  present  value  of  the  plant,  when  it  is  reasonably  applied  and 
when  the  cost  of  reproducing  the  property  may  be  ascertained 
with  a  proper  degree  of  certainty.  But  it  does  not  justify  the 
acceptance  of  results  which  depend  upon  mere  conjecture."  .  .  . 
"And  where  the  inquiry  is  as  to  the  fair  value  of  the  property, 
in  order  to  detei-mine  the  reasonableness  of  the  return  allowed  by 
the  rate  making  power,  it  is  not  admissible  to  attribute  to  the 
property  owned  by  the  carriers  a  speculative  increment  of  value, 
over  the  amount  invested  in  it  and  beyond  the  value  of  similar 
property  owned  by  others,  solely  by  reason  of  the  fact  that  it  is 
used  in  the  public  service.  That  would  be  to  disregard  the  essen- 
tial conditions  of  the  public  use,  and  to  make  the  public  use 
destructive  of  the  public  right."  (Minnesota  Rate  cases;  230 
U.  S.  352,  June  9,  1913). 

While  prices  in  the  United  States  had  gradually 
risen  from  1896  to  1915,  many  of  the  processes  of 
construction  had  been  so  greatly  improved  that  with 
few  exceptions  unit  prices  did  not  show  any  great 
change.  Steel  rails  stood  at  the  same  figure  for 
many  years,  and  while  some  commodities  such  as 


FAIR  VALUE  AND  THE   RETURN        45 

ties  and  timber  were  higher,  others  like  cement  were 
lower. 

The  large  volume  of  construction  in  the  later 
years  of  the  period,  especially  in  electric  light  anc^ 
power  and  telephone  utilities  tended  to  make  the 
actual  investment  considerably  higher  than  any  re- 
production estimate  would  show,  especially  if  made 
at  the  period  of  low  prices.  As  a  matter  of  fact 
replacements  made  between  1896  and  1915  were 
probably  sufficiently  extensive  to  bring  the  actual 
cost  of  existing  property  well  up  to  the  1910  level. 
In  other  words  a  properly  made  reproduction  esti- 
mate in  the  period  1910  to  1915  represented  ap- 
proximately the  actual  money  expended  on  the 
property  up  to  the  same  date,  although  it  is  probable 
that  more  or  less  of  this  money  had  been  expended 
for  replacements  which  had  been  charged  to  oper- 
ating expenses. 

A  1920  valuation,  on  the  basis  of  1920  prices, 
would  give  a  figure  more  than  double  the  actual 
investment  in  the  case  of  old  properties.  The  older 
the  property  and  the  less  its  growth  after  1915,  the 
greater  would  be  the  discrepancy  between  invest- 
ment and  reproduction. 

When  the  corporations  began  appealing  for  relief 
in  1916  and  1917,  and  valuations  were  made  using 
the  then  cost  of  reproduction,  the  commissions  gen- 
erally took  the  position  that  pre-war  prices  consti- 
tuted the  correct  basis  and  that  prices  of  the  two  or 
three  years  later  were  abnormal. 

One  interesting  and  significant  case  is  the  Brook- 
lyn Borough  Gas  Company  vs  Public  Service  Com- 


46      DEPRECIATION   OF   PUBLIC   UTILITIES 

mission  for  the  First  District  of  New  York,  P.  U.  R. 
19181*^  in  which  former  Justice  Charles  E.  Hughes, 
who  wrote  the  Minnesota  rate  case  decision,  acted 
as  referee.  This  case  was  decided  in  July,  1918, 
a  few  months  before  the  close  of  the  war,  in  thft 
midst  of  a  world-wide  confusion.  It  is  quoted  for 
the  purpose  of  pointing  out  the  parallel  between 
this  decision  and  the  Minnesota  rate  cases  already- 
quoted  ^  in  the  matter  of  *' hypothetical  estimates." 
Judge  Hughes  held  that : 

"To  base  rates  upon  a  plant  valuation  simply  representing  a 
hypothetical  cost  of  reproduction  at  a  time  of  abnormally  high 
prices  due  to  exceptional  conditions  would  be  manifestly  unfair 
to  the  public,  and  likewise  to  base  rates  upon  an  estimated  cost 
of  reproduction  far  lower  than  the  actual  bona  fide  and  prudent 
investment  because  of  abnormally  low  prices  would  be  unfair 
to  the  company  ...  To  take  as  the  basis  for  a  compensatory 
return  an  asserted  plant  value  far  above  the  actual  investment 
which  is  reached  merely  by  expert  estimates  of  a  cost  of  repro- 
duction under  abnormal  conditions  .  .  .  would  result  in  allowing 
a  public  service  corporation  to  take  advantage  of  a  public  calam- 
ity by  increasing  its  rates  above  what  would  be  a  liberal  return, 
not  only  on  actual  investment,  but  upon  a  normal  reproduction 
cost  .  .  . 

"When  the  value  of  a  plant  has  been  properly  determined  by 
the  regulating  authority,  and  suitable  allowance  is  made  for  the 
investment  in  subsequent  additions,  it  is  manifestly  proper  to 
calculate  the  fair  return  upon  this  basis,  at  least  for  a  reasonable 
period.  In  the  present  ease,  the  interval  has  been  one  of  unusual 
circumstances  incident  to  war  and  of  especially  high  costs,  and 
there  is  no  reason  why  there  should  be  substituted  for  the  official 
appraisal  a  hypothetical  estimate  of  reproduction  cost  under 
abnormal  conditions  reaching  an  amount  vastly  in  excess  of  the 
actual  investment." 

*  See  page  44, 


FAIR  VALUE  AND  THE  RETURN    47 

Following  this  decision,  the  general  tendency  on 
the  part  of  the  various  state  commissions  was  to 
hold  that  either  an  average  of  prices  over  a  term 
of  years,  or  a  recognition  of  actual  costs  on  parts 
of  the  property  built  during  a  period  of  high  prices 
combined  with  pre-war  costs  on  old  property  con- 
stitutes a  reasonable  basis. 

There  is  a  distinct  note  of  conservatism  in  the 
earlier  Supreme  Court  decisions  regarding  the  use 
of  standards  which  rest  on  pure  hypothesis,  and 
nothing  could  be  more  conjectural  or  hypothetical 
than  to  place  a  so-called  *' value"  on  a  unit  of  prop- 
erty, such  as  an  electric  power  house  built  twenty 
or  more  years  ago  and  of  a  type  now  obsolete,  which 
is  from  100  per  cent  to  125  per  cent  in  excess  of  its 
known  actual  cost. 

On  June  2, 1919,  the  United  States  Supreme  Court 
decided  the  Lincoln  Gas  and  Electric  Light  Case, 
250  U.  S.  256.    Justice  Pitney  says : 

"The  decree  ought  to  be  modified  so  as  to  permit  complainant 
to  make  another  application  to  the  courts  for  relief  against  the 
operation  of  the  ordinance  hereafter,  if  it  can  show,  as  a  result 
of  its  practical  test  of  the  dollar  rate  since  May  1,  1915,  or  upon 
evidence  respecting  values,  costs  of  operation,  and  the  current 
rates  of  return  upon  capital  as  they  stand  at  the  time  of  bringing 
suit  and  are  likely  to  continue  thereafter,  that  the  rate  ordinance 
is  confiscatory  in  its  effect  under  the  new  conditions.  It  is  a 
matter  of  common  knowledge  that,  owing  principally  to  the 
world  war,  the  costs  of  labor  and  supplies  of  every  kind  have 
advanced  since  the  ordinance  was  adopted,  and  largely  since  this 
cause  was  last  heard  in  the  court  below.  And  it  is  equally  well 
known  that  annual  returns  upon  capital  and  enterprise  the  world 
over  have  materially  increased,  so  that  what  would  have  been  a 


48      DEPRECIATION    OF    PUBLIC  UTILITIES 

proper  rate  of  return  for  capital  invested  in  gas  plants  and 
similar  public  utilities  a  few  years  ago  furnished  no  safe  criterion 
for  the  present  or  for  the  future." 

A  careful  reading  of  this  does  not  indicate  that 
value  is  to  be  considered  as  variable.  The  cost  of 
operating  expenses  during  the  war  period,  and  the 
rate  of  return  for  capital  invested  are  the  two  ele- 
ments specifically  mentioned. 

There  is  nothing  in  the  Lincoln  Gas  case  which 
would  support  a  valuation  as  of  a  date  when  extreme 
high  prices  prevailed  as  a  base  for  making  rates  and 
determining  return  provided  sufficient  rates  were 
allowed  to  permit  the  payment  of  operating  ex- 
penses necessarily  incurred  at  a  time  of  high  prices 
and  a  rate  of  return  on  investment  which  was  ade- 
quate to  meet  the  conditions  of  the  times. 

The  year  1920  saw  the  highest  prices  which  had 
been  reached  in  the  United  States  in  over  fifty  years. 
The  extreme  peak  was  reached  in  the  autumn  of 
1920.  During  the  months  when  prices  were  soaring 
to  this  peak  several  cases  reached  the  Federal 
Courts  and  State  Supreme  Courts,  and  were  decided 
in  the  autumn  of  1920  almost  at  the  time  of  the 
extreme  maximum  of  prices. 

The  Elizabethtown  Gas  Company  case  decided  by 
the  Supreme  Court  of  New  Jersey  on  Aug.  7, 
1920;  The  Consolidated  Gas  Company  case  decided 
by  the  District  Court  Southern  District  of  New 
York  on  Aug.  11,  1920  (267  Fed.  231);  The  St. 
Joseph  Light  Heat  and  Power  case  decided  by  the 
United  States  District  Court  for  the  Western  Dis- 
trict of  Missouri  on  Nov.  10,  1920,  P.  U.  R.  1921 


FAIR  VALUE  AND  THE  RETURN   49 

A  540;  and  Landon  vs  Kansas  Court  of  Industrial 
Relations,  decided  by  the  United  States  District 
Court  of  Kansas  on  Dec.  22,  1920,  P.  U.  R.  1921 
A  807;  all  squarely  hold  for  reproduction  at  prices 
as  of  the  time  of  the  investigation  as  constituting  a 
fair  rate  base. 

While  these  cases  constitute  a  strong  argument 
for  the  advocates  of  valuation  of  all  property  at 
prices  then  prevailing  irrespective  of  the  time  of 
construction  or  of  the  actual  investment,  it  seems 
that  one  would  do  well  to  pause  before  accepting 
these  dicta  as  the  final  word  on  valuation. 

In  considering  the  Consolidated  Gas  case,  267 
Fed.  231  it  must  be  remembered  that  this  case  was 
decided  Aug.  11,  1920,  at  the  extreme  high  peak  of 
prices.  Bradstreet's  Commodity  Index,  plotted  as 
a  curve  shows  a  steady  rise  from  8.6  in  1914  to  19.2 
in  1918  with  a  fluctuating  curve  reaching  20.7  in 
April,  1920  and  19.3  in  July,  1920. 

It  is  interesting  to  conjecture  what  this  decision 
might  have  been  a  few  months  later  when  prices  had 
dropped  to  less  than  twelve.  These  were  the  con- 
ditions which  caused  the  court  to  say: 

"Several  reasons  lead  me  to  believe  that  present  price  levels 
are  not  merely  transitory,  though  I  recognize  the  danger  of  any 
prophecy.  Whatever  their  precise  cause,  it  is  universally  con- 
ceded to  be  due  to  the  Great  War,  and  by  that  I  mean,  of  course, 
not  to  the  prosecution  of  hostilities,  but  to  the  economic  exhaus- 
tion and  inflation  of  the  circulating  medium  which  these  involved. 
In  general,  it  is  a  safe  inference  to  suppose  that  Europe  will  not 
be  able  to  resume  its  ante  helium  production  for  a  time  measured 
rather  by  years  than  by  months,  and  that  the  recovery  of  a  sound 
financial  condition  will  take  longer.     We  in  this  country  are  not 


50      DEPRECIATION   OF   PUBLIC   UTILITIES 

only  influenced  by  conditions  in  Europe,  but  we  are  subject  to 
our  own  local  inflation  and  disorganization  of  industry,  from 
which  no  one  can  know  when  we  shall  recover.  The  question  is 
a  practical  one,  and  comes,  I  think,  down  to  this: 

"The  plaintiff  is  faced  with  a  condition  which  permits  it  to 
receive  much  less  than  the  return  which  the  statute  contemplated, 
and  which  the  Constitution  is  thought  to  insure  it.  So  far  as 
human  foresight  can  see,  that  condition,  though  probably  not 
permanent — certainly  in  its  present  exaggerated  form — is  bound 
to  exist  over  a  period  of  some  years,  at  least  in  such  things  as 
coal,  oil,  and  labor,  which  are  the  plaintiff's  chief  costs.  There 
is,  then  the  certainty  of  a  continued  loss  for  an  indefinite,  but 
substantial,  time,  due  to  causes  which  were  not  in  existence  and 
could  not  jjossibly  have  been  apprehended  14  years  ago,  when 
the  rate  was  fixed.  Does  this  prospect  justify  the  court  in  aban- 
doning the  inertia  which  it  properly  feels  when  the  complaint 
is  based  upon  temporary  variations'?  Is  it  fair  to  continue  to 
impose  a  rate  which  has  clearly  ceased  to  correspond  with  the 
underlying  presuppositions  upon  which  it  was  based?  I  think 
that  the  prospect  does  justify  the  court,  and  that  the  rate  has 
become  unfair,  at  least  until  the  conditions  change." 

This  case  was  appealed  and  the  Supreme  Court 
rendered  its  opinion  on  March  6,  1922.  In  this 
opinion  the  court  modifies  the  decree  of  the  lower 
court  and  affirms  it  as  modified,  remanding  for 
further  hearings. 

There  is  no  discussion  of  the  question  of  basis  for 
rates  which  gives  a  clear  idea  as  to  what  the  court 
may  finally  decide,  but  it  seems  to  be  significant  that 
Justice  McEeynolds  quotes  from  the  report  of 
Special  Master  A.  S.  Gilbert,  the  following  conclu- 
sions : 

United  States  Supreme  Court,  Advance  Opinions, 
April  15,  1922,  p.  305: 


FAIR  VALUE  AND  THE  RETURN        51 

"On  the  basis  of  the  prices,  rates  of  pay,  and  costs  prevailing 
during  the  eight  months  beginning  Jan.  1,  1919,  the  cost  of 
making  and  distributing  gas  has  been  such  as  to  allow  a  very 
small,  if  any,  return,  on  even  the  actual  investment;  and  since 
Sept.  1,  1919,  the  cost  of  making  and  distributing  gas  has  been 
increased  in  a  number  of  respects  so  that  the  fair  inference  is 
that  the  complainant  company  now  finds  itself  without  any  return 
upon  the  investment.  The  conditions  found  by  me  have  existed 
for  more  than  a  year  last  past,  and  to  a  lesser  degree  for  at  least 
a  year  before  that  time,  and  will  continue  for  at  least  a  consider- 
able period  of  time,  the  end  of  which  cannot  now  be  forecast. 
Upon  such  a  situation  and  such  a  prospect,  I  think  that  the  com- 
plainant company  has  shown  itself,  clearly  and  beyond  all  reason- 
able doubt,  entitled  to  relief  from  the  statutory  limitation  on  its 
rates,  but  that  its  rate  of  return  should  be  calculated,  not  upon 
the  present  high  reproduction  cost  of  its  property,  with  or 
without  the  deduction  of  observed  or  actual  depreciation,  in 
whatever  manner  computed,  but  upon  the  actual,  reasonable,  in- 
vestment in  the  property  devoted  to  the  service  of  the  complain- 
ant's consumers." 

After  the  cases  in  the  Federal  Courts  referred 
to  were  decided,  and  these  cases  form  the  chief  basis 
for  the  argument  for  higher  prices,  the  Galveston 
case  was  decided,  by  the  District  Court  of  the  South- 
ern District  of  Texas  on  Feb.  10,  1921,  and  affirmed 
by  the  Supreme  Court  on  May  15,  1922.  District 
Judge  Hutcheson  holds,  Galveston  Electric  Com- 
pany vs  Galveston,  272  Fed.  147,  on  pages  156  and 
157: 

"It  was  the  view  of  the  master,  and  I  adopt  it,  that  the  prices 
obtaining  at  the  time  of  the  valuation  were  transitory,  or,  to  use 
the  language  of  the  Supreme  Court  in  the  Lincoln  Case,  it  was 
his  view  that  they  were  not  'likely  to  continue  thereafter.'  It 
was  his  view,  and  I  concur  with  him,  that  a  price  level  of  about 


52      DEPRECIATION   OF  PUBLIC  UTILITIES 

one-third  above  the  agreed  cost  submitted  to  him  could  reasonably 
be  assumed  to  have  sufficient  permanency  to  base  a  finding  on. 

"The  Supreme  Court  has,  in  1919,  stated  that  it  was  a  matter 
of  common  knowledge  that  costs  of  labor  and  supplies  of  every 
kind  have  greatly  advanced.  I  think  it  is  equally  a  matter  of 
common  knowledge  that  all  of  these  costs  are  on  the  decline, 
and  just  as  in  the  last  half  of  1919  and  the  first  half  of  1920  the 
phenomenon  of  higher  and  yet  higher  prices  was  of  worldwide 
scope  and  universal  experience,  now  the  phenomenon  of  lowering 
and  ever-lowering  prices  is  equally  manifest. 

"In  the  hearing  before  me  supplementary  to  that  before  the 
master,  the  evidence  as  to  price  trends  was  marked.  Indices  on 
commodity  prices  furnished  by  the  Bureau  of  Labor  Statistics 
showed  a  decline  from  September,  1920,  which  were  the  figures 
obtainable  when  the  master  made  his  report,  from  250  to  189 
on  all  commodities,  with  an  accelerating  drop  for  each  ensuing 
month,  and  the  testimony  sustained  this  view.  Since  that  time, 
the  current  financial  news  of  the  world,  which  I  think  is  a  matter 
which  this  court  can  take  judicial  knowledge  of,  as  shown  in 
standard  financial  publications,  is  to  the  effect  that  the  process 
of  deflation  has  not  been  completed;  that  there  are  still  many 
channels  in  which  the  price  reductions  recorded  are  inadequate  to 
meet  the  requirements  for  a  return  to  stable  conditions ;  that  these 
reductions  are  not  only  coming  in  materials,  but  necessarily  in 
the  labor  which  enters  into  their  production,  increased  and 
hastened  by  the  great  increase  in  unemployment,  the  shutting 
down  of  plants,  and  the  resumption  of  such  as  do  resume  on  wage 
reductions. 

"According  to  the  Bankers'  Commodity  Price  Index,  the 
average  price  of  all  commodities  was  on  Jan.  1,  1920,  439.30 
compared  with  358.77  on  Aug.  1,  1914,  or  an  increase  of  approx- 
imately only  331/3  per  cent.  Nothing,  however,  in  any  of  these 
views,  leads  me  to  believe  that  a  permanently  lower  price  level 
may  reasonably  be  reached  for  some  time  to  come  than  the  one 
taken  by  the  master  of  331/3  per  cent,  and  his  finding  on  this  point 
will  therefore  be  adopted  by  me  without  change." 

In  the  Supreme  Court  decision  ( U.  S. 


FAIR  VALUE  AND  THE  RETURN    5^ 

Advance  Opinions  No.  13,  May  15,  1922,  p.  383), 
Justice  Brandeis  does  not  finally  settle  this  conten- 
tion as  to  the  base  value,  but  he  does  clearly  indicate 
that  certain  elements  are  not  to  be  included: 

"First,  As  the  base  value  of  the  property,  master  and  court 
took — instead  of  the  prudent  investment  value — the  estimated 
cost  of  reproduction  at  a  later  time,  less  depreciation;  and,  in 
estimating  reproduction  cost,  both  refused  to  use  as  a  basis  the 
prices  actually  prevailing  at  the  time  of  the  hearings.  These  had 
risen  to  100  per  cent  above  those  of  1913.  The  basis  for  cal- 
culating reproduction  cost  adopted  by  all  was  prophecy  as  to  the 
future  general  price  level  of  commodities,  labor,  and  money. 
This  predicted  level,  which  they  assumed  would  be  stable  for  an 
indefinite  period,  they  called  the  new  plateau  of  prices.  As  to 
the  height  of  this  prophesied  plateau,  there  was  naturally  wide 
divergence  of  opinion.  The  company's  expert  prophesied  that 
the  level  would  be  60  to  70  per  cent  above  1913  prices ;  the  master, 
that  an  increase  of  SSVs  per  cent  would  prove  fair;  and  the 
court  accepted  the  master's  prophecy  of  SSVs  per  cent." 

This  case  is  of  chief  interest  in  its  discussion  of 
going  concern  values.  This  subject  is  not  under 
consideration  in  this  volume  but  the  conclusion  of 
the  court  does  bear  definitely  on  the  question  of 
**fair  value."    It  is  quoted  for  that  reason: 

"Nor  is  there  evidence  in  the  record  to  justify  the  Master's 
finding  that  a  business  brought  to  successful  operation  'should 
have  a  going  concern  value  at  least  equal  to  one-third  of  its 
physical  properties.'  Past  losses  obviously  do  not  tend  to  prove 
present  values.  The  fact  that  a  sometime  losing  business  becomes 
profitable  eventually,  through  growth  of  the  community  or  more 
efiicient  management,  tends  to  prove  merely  that  the  adventure 
was  not  wholly  misconceived.  It  is  doubtless  true,  as  the  Master 
indicated,  that  a  prospective  purchaser  of  the  Galveston  system 


64      DEPRECIATION  OF  PUBLIC  UTILITIES 

would  be  willing  to  pay  more  for  it  with  a  record  of  annual 
losses  overcome,  than  he  would  if  the  losses  had  continued.  But 
would  not  the  property  be,  at  least,  as  valuable  if  the  past  had 
presented  a  record  of  continuous  successes?  And  shall  the  base 
value  be  deemed  less  in  law  if  there  was  no  development  cost, 
because  success  was  instant  and  continuous?  Or,  if  the  success 
had  been  so  great  that,  besides  paying  an  annual  return  at  the 
rate  of  8  per  cent,  a  large  surplus  had  been  accumulated,  could 
the  city  insist  that  the  base  value  be  reduced  by  the  amount  of 
the  surplus?  Compare  Newton  vs  Consolidated  Gas  Company, 
decided  March  6,  1922,  U.  S.  ante,  306,  42  Sup.  Ct.  Rep.  264. 

"Going  concern  value  and  development  cost,  in  the  sense  in 
which  the  master  used  these  terms,  are  not  to  be  included  in  the 
base  value  for  the  purpose  of  determining  whether  a  rate  is 
confiscatory. 


"The  appellant  insisted  also  that  the  base  value  should  be 
raised  by  assuming  that  the  future  plateau  of  prices  would  be 
60  to  70  per  cent  above  the  historical  reproduction  value,  instead 
of  331/3  per  cent,  as  the  Master  and  the  court  assumed.  The 
appellees  insisted,  on  the  other  hand,  that  an  item  of  $142,281 
for  grade  raising,  included  by  Master  and  court  in  the  historical 
cost,  should  be  eliminated.  We  cannot  say  that  there  was  error 
in  overruling  these  contentions." 

Two  other  Supreme  Court  cases,  decided  in  the 
spring  of  1922  must  not  be  overlooked. 

New  York  and  Queens  Gas  Company  vs  Newton 
is  notable  in  that  the  Master's  report  is  presented 
in  full  as  part  of  the  Federal  Court's  opinion  (269 
Fed.  277)  and  was  given  full  approval.  Justice 
McReynolds  in  a  short  opinion  handed  do^^^l  on 
March  6,  1922,  Advance  Opinions,  April  15,  1922, 
p.  309,  affirms  the  decree  of  the  Federal  Court. 

The  Master  accepts  actual  investment  in  the  prop- 


PAIR  VALUE  AND  THE  RETURN   55 

erty  as  the  basis  of  fair  present  value.    See  Appen- 
dix. 

The  last  case  to  be  decided  was  City  of  Houston 
vs  Southwestern  Bell  Telephone  Company,  decision 
May  29,  1922,  Justice  Clarke  said : 

"We  think  .  .  .  that  the  proper  basis  for  rate  making  in  the 
case  is  the  fair  value  of  the  property,  useful  and  used  by  the 
company,  at  the  time  of  inquiry." 

The  net  result  of  the  recent  decisions  would  seem 
to  indicate  that  both  advocates  of  the  theory  of  In- 
vestment, and  those  of  Valuation  as  of  the  date  of 
inquiry,  have  grounds  to  hope  that  there  is  a  decided 
prospect  of  a  decision  favorable  to  the  contention 
which  they  support. 

It  certainly  is  an  open  question.  The  cases  de- 
cided have  all  been  such  that  this  issue  was  not 
controlling. 

Unless  a  rate  of  return  on  any  property  is  high 
enough  to  permit  the  owners  of  that  property  to  go 
into  the  financial  markets  and  secure  the  money 
necessary  for  making  needed  extensions  to  the 
property,  it  is  not  an  adequate  rate.  It  would  ap- 
pear that  there  should  be  little  ground  for  contro- 
versy regarding  the  claim  that  in  order  to  be  *'fair" 
a  rate  must  be  such  as  would  attract  capital  to  the 
property. 

Such  being  the  fact,  in  times  of  stress  such  as  we 
have  been  going  through,  with  rates  for  service  of 
all  kinds  being  constantly  changed,  it  would  seem 
to  be  clear  that  when  a  property  which  had  been 
able  to  borrow  money  at  5  to  6  per  cent  is  compelled 


56      DEPRECIATION  OF  PUBLIC  UTILITIES 

to  pay  10  or  11  per  cent  or  more,  there  must  either 
be  an  increase  in  the  rate  of  return  allowed  on  the 
property  or  that  the  growth  of  the  property  must 
be  immediately  restricted. 

While  the  same  result  is  obtained,  in  dollars,  by 
doubling  the  value  of  the  property  at  the  old  rate 
of  return,  as  would  be  obtained  by  doubling  the  rate 
on  the  original  valuation,  it  would  seem  to  be  a  wiser 
policy  to  adopt  the  latter  course. 

The  Indiana  Public  Service  Commission,  in  re 
Laporte  Gas  and  Electric  Company,  P.  U.  R.  1921  A, 
824,  decided  Dec.  22,  1920,  holds  that  one  of  the 
most  important  considerations  in  determining  fair 
value  for  purposes  of  rate  making  is  the  elimination 
of  *'the  speculation,  hazards,  and  destructive  re- 
verses to  which  non-utility  property  constantly  is 
subjected. ' '    The  commission  holds  that : 

"The  most  certain  and  effective  method  to  do  this  is  to  adopt 
a  principle  which  will  insure  a  lasting  stability  to  utility  values. 
The  surest  and  most  equitable  method  of  insuring  stability  of 
values  is  to  consider  prudent  investment  as  the  primary  factor 
of  value. 

"Facing  as  this  country  does,  a  period  of  economic  uncertainty, 
there  is  now  a  dire  need  for  the  stabilization  of  utility  values. 
Values  and  service  go  hand  in  hand,  and,  if  values  are  unstable 
or  impaired,  service  may  likewise  be  unstable  and  impaired. 

"The  investment  principle  insures  the  utility  against  the  evil 
effects  of  recurrent  fits  of  economic  fortune,  which  under  any 
other  theory  of  valuation  must  in  varying  degree  be  suffered  by 
public  service  companies." 

From  the  standpoint  of  sound  economics  the  large 
group  of  public  utility  properties  which  have  been 


FAIR  VALUE  AND  THE  RETURN   57 

built  with  due  regard  to  business  judgment  and 
which  serve  a  real  need  in  the  communities  in  which 
they  are  located  should  be  put  on  a  basis  of  the 
utmost  stability. 

We  are  securing  excellent  results  from  the  regu- 
lation of  these  properties.  The  whole  trend  of  reg- 
ulation of  capital  issues  and  of  accounting  has  been 
toward  stabilization,  the  elimination  of  the  specu- 
lative element  in  securities,  and  the  compelling  of 
such  methods  of  accounting  as  will  properly  differ- 
entiate between  capital  expenditures  and  operating 
expenses. 

No  valuation  can  be  made  which  inflates  capital 
to  a  point  far  beyond  actual  investment  without 
challenging  the  strenuous  opposition  of  the  rate 
payers,  and  when  such  valuation  is  coupled  with  a 
demand  for  higher  rates  on  account  of  existing 
market  conditions  a  burden  is  placed  on  the  rate 
payer  which  is  bound  to  increase  the  opposition. 

One  does  not  need  to  double  both  the  valuation 
of  his  property  and  the  rate  of  return  in  order  to 
secure  justice.  The  problem  is  to  secure  justice, 
and  at  the  same  time  to  secure  stability  of  values 
and  freedom  from  costly  litigation. 

So-called  sound  investments,  such  as  investment 
in  bonds,  or  mortgages  or  a  deposit  in  a  savings 
bank  are  not  increased  in  amount  when  the  value 
of  the  dollar  changes.  It  is  true  that  investments 
in  public  utilities  are  not  like  investment  in  bonds 
and  mortgages,  but  it  is  equally  true  that  they  are 
not  like  investments  in  unregulated  business  free  to 
earn  all  that  they  can.     The  hundreds  of  millions 


58      DEPRECIATION   OF  PUBLIC   UTILITIES 

of  dollars  of  public  utility  securities  outstanding 
when  the  war  commenced  did  not  have  their  face 
value  increased  nor  yet  their  rate  of  return.  It  was 
only  in  the  relatively  small  percentage  of  cases 
where  a  refinancing  was  necessary  that  the  owners 
of  such  securities  forced  any  better  bargain  from 
the  utilities  than  the  one  first  made. 

The  argument  has  been  advanced  that  the  present 
day  reproduction  cost  is  the  proper  figure  because 
in  the  event  of  a  sale  of  the  property  this  price 
would  prevail.  The  answer  to  this  argument  is  that 
there  are  no  sales  of  such  properties  being  made 
at  times  of  maximum  prices. 

Many  illustrations  may  be  found  or  a  large  prop- 
erty, of  replacements  of  large  units  at  prices  greatly 
in  excess  of  the  cost  of  the  original  unit.  One  case 
was  that  of  a  generator  unit  at  $23,000  replacing  an 
old  one  which  cost  $11,000.  The  replacement  was 
of  property,  not  dollars.  The  present  sale  value  of 
the  generator  was  more  than  twice  as  many  dollars 
as  formerly.  They  were  cheap  dollars.  Their  pur- 
chasing power  was  no  more  than  that  of  the  original 
smaller  number  of  dollars.  The  relatively  few  such 
cases  on  the  majority  of  properties  do  not  justify 
the  sale  argument.  It  may  be  granted  that  a  sale 
price  would  have  to  be  high  enough  to  give  the  seller 
sufficient  dollars  to  buy  as  much  as  he  could  have 
bought  originally  with  his  original  money  in  hand. 
There  has  been  no  market  for  utility  properties  dur- 
ing the  period  of  peak  prices.  No  sane  business 
man  would  invest  under  the  conditions  shown  by 


FAIR  VALUE  AND  THE  RETURN   59 

the  companies  in  their  presentation  of  arguments 
for  higher  rates. 

In  1921  a  memorandum  was  filed  with  the  depre- 
ciation section  of  the  Bureau  of  Accounts  of  the 
Interstate  Commerce  Commission,  bearing  on  de- 
preciation charges,  by  Robert  A.  Carter,  Chairman 
of  the  Committee  on  rate  fundamentals  of  the 
American  Gas  Association,  and  William  L.  Ransom 
of  the  New  York  Bar. 

The  following  statement  is  quoted  from  page  3 
of  this  memorandum : 

"We  desire  greatly,  in  the  first  place,  to  furnish  an  efficient  and 
acceptable  service  to  all  our  consumers  and  patrons,  and,  in  the 
second  place,  to  charge  them  a  rate  no  higher  than  is  absolutely 
necessary  to  reimburse  us  for  operating  expenditures  actually 
made,  and  yield,  in  addition,  a  fair  return  on  our  actual  invest- 
ment as  judicially  established.  We  adhere  to  that  standard  in 
the  fixation  of  the  rates  charged  by  our  companies;  we  desire 
that  railroads  and  regulated  utilities  whose  service  we  require  in 
the  carrying  on  of  our  business,  shall  do  the  same  thing.  The 
amount  of  money  which  we  have  to  pay  out  for  freight  rates 
becomes  a  large  item  in  our  operating  costs;  and  we,  in  turn,  as 
patrons  of  railway  service,  do  not  wish  to  pay  excessive  rates  or 
rates  inflated  by  fictitious  charges,  in  the  guise  of  operating  ex- 
penses or  anything  else." 

One  of  the  most  thoughtful  analyses  of  the  legal 
decisions  bearing  on  the  subjects  of  fair  value  and 
of  fair  return  is  that  of  Professor  Edwin  C.  God- 
dard  in  Michigan  Law  Review  for  January,  1917. 
His  conclusions  in  part  are  as  follows: 

"In  conclusion  may  we  hope  for  the  adoption  of  one  clear  and 
definite  theory  of  valuation  to  the  exclusion  of  all  others,  except 
as  they  may  be  needed,  for  a  time,  in  checking  uncertainties  or 


60      DEPRECIATION  OF  PUBLIC   UTILITIES 

supplying  deficiencies  because  of  lack  of  reliable  records  or 
proper  systems  of  accounting?  A  satisfactory  answer  to  this 
question  must  rest  on  something  more  fundamental  than  a  com- 
parison of  the  workableness  and  relative  advantages  of  the  vari- 
ous theories.  It  must  rest  upon  the  basic  principles  of  the  rela- 
tions of  the  public  to  public  utilities.  A  public  utility  is  some- 
thing the  public  needs.  It  may  build  the  utility  as  a  public 
enterprise  or  leave  it  to  private  capital.  If  it  pursue  the  latter 
course  it  practically  says  to  capital,  construct  and  manage  the 
utility  reasonably  and  the  public  will  make  every  reasonable 
effort  to  insure  a  fair  return  on  the  investment.  Taney  prices 
and  fancy  profits  alike  are  not  allowed,  but  steady,  reliable 
promise  should  attract  capital.  The  returns  should  be  primarily 
what  is  fair,  first  and  foremost,  to  the  public,  and  second  to  the 
public  service,  in  every  ease  to  both,  if  possible.  Enough  has 
been  said  about  what  is  fair  to  the  public,  the  rate  must  be  reason- 
able. Then,  if  consistent  with  such  reasonable  charge  to  the 
public,  the  public  must  allow  the  service  to  earn  a  reasonable 
return.  But  on  what?  Much  of  the  difficulty  here  arising  is  due 
to  a  failure  to  distinguish  between  investment  in  private  and 
in  public  enterprises.  Public  utilities  have  been  speculated  in 
like  private  business  adventures,  but  nearly  always  with  results 
disastrous  to  the  public  receiving  the  service,  and  to  most  of  the 
public  investing  in  the  securities.  What  the  public  needs  is  a 
stability  in  the  public  service  property  that  will  attract  sufficient 
capital  to  furnish  satisfactory  services.  The  great  majority  of 
those  furnishing  the  capital  seek  a  safe  and  sure  return,  not 
on  speculative  values  but  on  money  adventured.  The  few  who 
may  have  grown  very  rich  or  very  poor  in  speculations  in  public 
utilities  may  be  dismissed.  Their  interests  are  usually  adverse  to 
the  good,  alike  of  the  public  and  the  ordinary  stockholder.  Our 
public  utilities  today  are  maintained  on  money  furnished  by  many 
millions  of  our  people,  and  it  is  desirable  that  it  should  be  so. 
To  secure  this  there  should  be  reasonable  assurance  to  investors 
of  fair  earnings.  On  what?  Why,  on  the  investment,  on  what 
(under  proper  conditions)  has  been  put  into  the  public  use. 

"In  this  connection  the  use  of  the  terms  'value'  and  'valua- 
tion' is  unfortunate.    It  is  not  value  in  any  ordinary  sense  that 


FAIR  VALUE  AND  THE   RETURN        61 

is  being  sought,  as  has  often  been  noticed.  The  basis  for  all 
dealings  involving  purchase  and  rate  making  should  be,  not 
actual  cost,  not  reproduction  cost,  not  market  value,  not  stock 
and  bond  issue.  It  should  be  what  has  been  well  called  the 
'efficient  investment,'  i.e.,  the  actual  amount  honestly  and 
prudently  invested  in  the  utility,  under  normal  conditions;  no 
more,  no  less.  The  'efficient  investment'  theory  eliminates  all 
consideration  of  losses  due  to  mismanagement.  Those  must  be 
charged  against  stockholders.  'The  Company  is  held  to  the  same 
standard  of  honesty  and  prudence  in  the  management  and  main- 
tenance as  in  the  original  acquisition  of  its  properties.'  It  takes 
no  account  of  bad  property  investments,  it  eliminates  all  the 
objectionable  elements  that  have  been  urged  against  the  actual 
cost  theory.  As  it  has  been  stated  in  a  recent  case  by  the  Wash- 
ington Commission,  'It  would  seem  equitable,  just  and  fair  that 
the  public  should  be  required  to  furnish  fair,  just  and  reasonable 
compensation  for  the  reasonable  and  necessary  detriment  a 
utility  has  suffered  by  reason  of  its  service  to  the  public' 

"But  not  only  is  a  fair  return  on  the  'efficient  investment' 
fair  and  just,  its  practical  advantage  is  that  it  is  a  fixed  and 
not  a  shifting  thing.  Reproduction  value  is  as  unstable  as  water. 
Efficient  investment  represents,  not  what  the  public  does  for  the 
property  of  the  company,  but  what  the  company  does  for  the 
public.  It  does  not  dejDend  on  money  market,  or  rates,  or  market 
prices  of  labor  or  material,  or  on  values  created  by  the  public  and 
not  by  the  service.  It  does  not  change  with  hard  times,  or 
shifting  population,  or  the  fickle  and  varying  judgments  of 
appraisers  or  courts.  It  is  a  certain  and  fixed  amount  which  is 
determined  for  all  time.  It  is  only  a  matter  of  proper  bookkeep- 
ing to  keep  it  up  so  as  to  show  its  amount  as  of  any  given  date. 
It  is  a  standard,  fixed,  natural,  'rate  base'  from  which  the  service 
flows,  and  on  which  all  relations  between  the  service  and  the 
public  should  rest.  'The  old  methods  have  proven  uncertain, 
indefinite,  and  unsatisfactory  to  honest  utilities  and  commissions 
alike.  Their  chief  use  has  been  to  furnish  an  easy  method  to 
conceal  inflated  values  and  dubious  flnancial  transactions.'  A 
method  is  needed  'that  will  eliminate  speculation,  allow  the  honest 
investor  to  prosper,  and  destroy  the  crooked  financier.' " 


62      DEPRECIATION   OF   PUBLIC   UTILITIES 

This  question  of  "fair  value"  will  probably  be  dis- 
posed of  by  the  highest  courts  in  a  short  time;  but 
until  so  settled  it  constitutes  the  chief  point  of  con- 
tention which  has  been  created  by  the  changing 
prices  of  recent  years. 

The  issues  clearly  are  as  follows: 

As  to  Value,  we  must  either  accept  investment 
where  known,  or  some  split  standard  of  valuation 
such  as  that  suggested  by  Charles  E.  Hughes  in  the 
Brooklyn  Borough  Case  which  will  give  a  figure 
closely  approximating  investment,  in  the  attempt  to 
secure  stable  valuation,  or  we  must  accept  prices  as 
of  the  time  of  inquiry,  which  means  for  the  future 
constantly  lowering  values  and  ultimately  the  wip- 
ing out  of  large  investments  necessarily  made  be- 
tween 1917  and  1921. 

As  to  rate  of  return,  we  must  either  accept  the 
theory  that  the  fair  rate  is  that  rate  which  will  per- 
mit the  utility  to  secure  the  capital  it  needs,  and 
that  the  rate  varies  with  the  money  market,  or  we 
must  fall  back  on  the  theory  that  the  fluctuating 
value  of  property  will  give  sufficient  return  for  our 
needs. 

Public  policy  will  certainly  not  permit  the  in- 
creased rate  on  the  arbitrarily  increased  valuation, 
hence  the  acceptance  of  the  varying  rate  involves 
the  acceptance  of  investment  as  the  standard  of 
value. 


CHAPTEB  VII 

FLUCTUATING  PRICES  AND  ACCOUNTING 
ALLOWANCES  FOR  REPLACEMENT 

Another  series  of  questions  present  themselves 
in  connection  with  the  price  changes  of  recent  years. 
If  the  cost  of  replacement  of  property  is  an  operat- 
ing expense,  and  it  clearly  is  such,  and  has  been  un- 
equivocally recognized  as  such  by  the  Supreme 
Court,  and  if  replacements  are  to  be  accounted  for 
either  by  directly  charging  to  operating  expenses, 
or  by  the  creation  of  reserves  for  replacement,  how 
shall  the  difference  between  the  cost  of  the  new  unit 
and  the  old  one  which  it  replaces  be  accounted  for? 

If  a  railroad  replaces  100-lb.  steel  rails  which 
originally  cost  $36  per  ton  with  rails  of  the  same 
weight  costing  $80  per  ton,  shall  it  charge  $36 
or  $80  to  operating  expenses?  If  the  former, 
shall  it  charge  the  $44  to  capital?  If  so,  is  this 
capital  entitled  to  its  "fair  return"?  When  the 
rails  are  next  renewed,  in  eight  or  ten  years,  if  the 
renewal  is  at  $32,  how  shall  the  capital  account  be 
treated? 

It  must  be  remembered  that  ''fair  return"  and 
** depreciation"  or  cost  of  replacement  must  both 
be  earned. 

63 


64      DEPRECIATION    OF    PUBLIC    UTILITIES 

Assuming  7  per  cent  as  a  fair  return,  and  assum- 
ing that  the  experience  of  the  railroad  shows  ten- 
year  renewal  periods  for  the  rail,  an  investment  in 
10,000  tons  of  rails  at  $36  would  affect  the  total 
earnings  of  the  property  to  the  extent  of  $61,200  per 
year  assuming  the  straight  line  method  of  comput- 
ing the  replacement  allowance  on  the  original  cost 
of  $36  per  ton. 

If  the  entire  $80  cost  of  rails  were  treated  as 
an  operating  expense,  and  no  change  made  in  the 
capital  account  it  would  be  necessary  to  raise 
$105,200  per  year  for  return  plus  replacement.  If 
the  capital  were  increased  by  $44  per  ton,  and 
the  replacement  allowance  established  on  the  basis 
of  the  actual  cost  of  the  new  rails,  which  would  be 
the  only  treatment  consistent  with  the  increase  of 
capital,  it  would  be  necessary  to  raise  $136,000  per 
year. 

If  the  compound  interest  method  be  used  instead 
of  the  straight  line  method  and  compound  interest 
figured  at  4  per  cent  per  annum,  the  figures  of  the 
two  latter  assumptions  would  change  to  $91,833  per 
year  and  $122,633  per  year. 

On  any  basis  of  computation  it  costs  the  rate 
payer  less  money  to  charge  the  entire  cost  of  the 
replacement  to  operating  expenses  and  provide  for 
retiring  it  at  its  cost  through  the  reserve  for  re- 
placement, than  it  does  to  compel  the  utility  to 
capitalize  the  excess  cost  and  then  provide  for  re- 
tiring it. 

In  the  assumed  case  there  is  no  new  property 
created  for  the  $440,000  of  new  capital.     There  is 


FLUCTUATING  PRICES  65 

nothing  which  could  be  offered  as  security  for  ad- 
ditional stocks  or  bonds.  If  this  practice  is  adopted, 
and  utilities  are  compelled  to  add  to  capital  when 
replacements  in  kind  are  made  at  a  higher  price,  it 
follows  that  they  must  be  compelled  to  deduct  from 
capital  when  renewal  is  made  at  a  lower  price; 
capital  must  be  protected  through  the  replacement 
reserve,  which  must  collect  the  entire  cost  of  the  unit 
so  that  the  investor  may  be  reimbursed  when  he  dim- 
inishes the  capital  by  replacement  at  a  lower  cost. 
This  procedure  would  greatly  add  to  the  difficulty 
and  uncertainty  of  accounting  for  replacement,  a 
thing  which  is  uncertain  enough  as  it  is. 

The  rate  payer  and  the  general  public  are  inter- 
ested in  knowing  that  there  is  no  doubling  of  charges 
through  increased  operating  expenses  due  to  replace- 
ment at  higher  costs,  while  at  the  same  time  in- 
creases are  made  in  "fair  value"  of  property  either 
through  the  building  up  of  capital  in  the  manner 
suggested  or  by  means  of  a  hypothetical  valuation. 

If  the  rate  payer  be  compelled  to  pay  the  cost  of 
replacement,  as  he  should  be,  no  increase  in  the 
capital  accounts  should  be  made  that  is  not  repre- 
sented by  actual  additions  or  betterments  paid  for 
by  the  investor.  The  investor  is  likewise  entitled 
to  full  recognition  of,  and  return  upon,  his  entire 
investment.  When  part  of  that  investment  was 
made  in  direct  response  to  the  demands  of  business 
during  the  war  period  it  should  be  treated  exactly 
as  pre-war  investment  is  treated,  and  so  long  as  the 
property  continues  to  operate  should  be  entitled  to 
its  fair  return. 


66      DEPRECIATION   OF  PUBLIC  UTILITIES 

The  investor  is  also  interested  in  knowing  that 
no  arbitrary  rule  of  accounting  for  replacements 
made  during  a  period  of  high  prices  will  compel  him 
to  capitalize  part  of  the  cost  of  operating  expenses 
and  increase  the  amount  of  outstanding  capital  on 
pre-existing  property,  unless  he  is  permitted  to 
make  full  provision  for  retiring  this  excess  capital- 
ization through  the  accumulation  of  reserves  ample 
to  reimburse  him  for  the  entire  cost  of  the  property 
in  question ;  as,  if  the  next  replacement  is  at  a  lower 
figure  there  should  be  a  large  enough  reserve  not 
only  to  cover  the  charge  to  operating  expense,  but 
also  enough  to  retire  the  excess  capital.  To  compel 
the  capitalizing  of  the  excess  cost  of  replacements 
practically  compels  the  requiring  of  reserve  account- 
ing and  complicates  the  problem  which  is  already 
giving  evidences  of  being  a  thing  which  will  cause 
much  trouble  before  it  is  fully  controlled. 

If  accounting  for  replacement  only  dealt  with  a 
few  items,  if  it  were  possible  to  keep  itemized  actual 
costs  of  all  renewals  and  base  the  accumulation  of 
reserves  on  these  actual  costs,  and  if  it  were  possible 
to  follow  through  in  the  accounts  year  after  year 
the  history  of  each  of  the  individual  items,  it  might 
be  possible  to  devise  accounting  rules  that  would 
give  accurate  results.  This  cannot  be  done  on  a 
large  property.  Where  the  raising  of  reserves  for 
replacements  is  based  wholly  on  somebody's  esti- 
mate, and  not  on  the  history  of  actual  expenditures, 
and  where  whole  groups  of  property  and  not  indi- 
vidual units  must  necessarily  be  dealt  with,  it  would 
seem  that  the  surest  way  to  secure  anything  ap- 


FLUCTUATING  PRICES  67 

proximating  reasonably  correct  accounting  for  re- 
placement would  be  to  treat  the  entire  cost  of  the 
replacement  as  an  operating  expense  and  not  to 
complicate  the  book  keeping  by  attempting  to  charge 
to  capital  any  part  of  the  excess  cost  of  the  new 
thing  over  the  thing  it  replaces. 

The  original  investment  was  in  property,  and  the 
court  has  held  that  it  is  ''that  property  and  not  the 
original  cost  of  it"  which  is  under  investigation  and 
is  being  valued.  It  would  appear  to  be  sound  to 
hold  that  a  renewal  of  ten  miles  of  100-lb.  rails  is 
the  thing  that  is  essential  to  continued  railroad 
service,  and  that  whether  the  present  cost  be  less 
or  be  more  than  the  original  cost  is  wholly  imma- 
terial. 

Where  reserves  are  required  the  variation  of  the 
amount  raised  from  year  to  year  is  wholly  within 
the  jurisdiction  of  the  commission,  and  these  vari- 
ations may  properly  reflect  changes  in  the  price  level 
in  order  to  insure  to  the  consumer  the  necessary 
continuity  of  service. 

The  discussion  in  this  chapter  applies  only  to 
the  treatment  of  excess  price  and  does  not  have 
any  reference  to  accounting  for  additions  which  in- 
crease the  weight,  or  capacity  to  render  service.  If 
the  renewal  be  made  of  120-lb.  rails  to  replace  100-lb. 
rails,  or  of  a  10,000-gal.  capacity  pump  to  replace 
one  of  7,500-gal.  capacity  there  is  in  reality  an  ad- 
dition to  the  original  property  which  ought  to  be 
provided  for  out  of  funds  of  the  investor. 


CHAPTER  VIII 

SUPREME  COURT  DECISIONS  BEARING  ON 
DEPRECIATION 

It  is  not  proposed  to  discuss  the  technique  of 
accounting  methods  for  Replacement  or  Deprecia- 
tion. Certain  matters  which  have  a  more  or  less 
direct  bearing  on  the  accounting  side  of  the  subject 
seem  not  to  have  been  given  sufficient  prominence 
in  the  books  or  articles  on  the  subject,  and  only  these 
things  will  be  touched  upon. 

The  most  exhaustive  discussion  of  accounting 
methods  and  principles  appears  in  the  final  report 
of  the  American  Society  of  Civil  Engineers'  Com- 
mittee {Trans.  Am.  Soc.  C.  E.,  Vol.  81, 1917,  pp.  1448 
to  1479  inch). 

There  is  a  thoroughly  excellent  treatment  of 
accounting  methods  in  *' Principles  of  Accounting" 
by  Paton  and  Stevenson  (1919)  pp.  482  to  527.  In 
''Railroad  Accounting"  by  Wm.  E.  Hooper  (1915), 
pp.  49  to  51  and  117  and  118  there  is  a  brief  discus- 
sion of  the  Interstate  Commerce  Commission  clas- 
sification as  it  has  a  bearing  on  Depreciation. 

"Modern  Accounting"  by  Professor  H.  R.  Hat- 
field (1910),  devotes  a  chapter  (pp.  121  to  143),  to 

68 


SUPREME  COURT  DECISIONS  69 

the  subject,  and  gives  a  bibliography  of  nine  articles 
or  books  referring  to  the  subject. 

A  study  of  the  various  articles  and  books,  in 
chronological  order  and  a  careful  review  of  all  cases 
reported  in  the  courts,  indicate  that,  prior  to  1900, 
there  was  but  little  general  recognition  of  the  im- 
portant principle  that  the  wearing  out  of  plant 
constitutes  one  important  element  of  the  cost  of 
production. 

The  American  Society  of  Civil  Engineers'  Com- 
mittee recognizes  the  propriety  of  two  general 
methods  of  accounting  for  replacement,  which  they 
term  ''Replacement  Method"  and  "Allowance 
Methods." 

The  replacement  method  consists  of  direct  charges 
to  operating  expense  at  the  time  of  renewal  of  units 
of  property,  while  the  various  allowance  methods 
spread  the  cost  of  the  unit  of  property  over  the 
estimated  life  of  the  unit  through  the  establishment 
of  accounting  reserves. 

As  has  already  been  pointed  out  the  main  reason 
if  not  the  sole  reason  for  the  adoption  of  any  allow- 
ance method  is  that  the  ratio  between  earnings  and 
operating  expenses  may  be  held  fairly  uniform  year 
after  year. 

The  American  Society  of  Civil  Engineers'  Com- 
mittee apparently  draws  the  conclusion  that  the  law 
as  laid  down  by  the  Supreme  Court  in  the  Knoxville 
case  requires  the  deduction  of  theoretical  computed 
depreciation  from  valuation  in  a  rate  case.  The 
writer  does  not  agree  with  this  conclusion.  While 
the  writer  was  a  member  of  this  Committee  and 


70      DEPRECIATION  OF  PUBLIC  UTILITIES 

acquiesced  in  the  report,  he  holds  the  view  that  a 
correct  construction  of  all  of  the  recent  decisions 
of  the  Supreme  Court  will  lead  to  a  considerable 
modification  of  the  statement  of  the  committee. 
This  subject  will  be  discussed  more  fully  later  in 
this  chapter. 

The  Knoxville  decision  (212  U.  S.  1,  Jan.  4,  1909) 
holds  that  the  cost  of  reproduction  must  be  dimin- 
ished by  'Hhe  depreciation  which  has  come  from  age 
and  use." 

In  this  case  the  company  made  an  elaborate 
analysis  of  the  cost  of  construction  and  in  arriving 
at  the  present  value  of  the  plant  made  large  deduc- 
tions on  account  of  depreciation  which  they  divided 
into  two  classes  ^'complete  depreciation"  and  ''in- 
complete depreciation." 

The  company  then  contended  that  in  fixing  upon 
a  reasonable  value  on  which  to  compute  the  return 
the  amounts  of  complete  and  incomplete  deprecia- 
tion sJiould  he  added  to  the  present  value  of  the 
surviving  parts. 

The  court  properly  negatived  this  contention  be- 
cause the  complete  depreciation  represented  parts 
of  the  plant  that  had  "actually  perished  as  useful 
property,"  while  the  incomplete  depreciation  rep- 
resented admitted  ''impairment  in  value"  of  the 
remaining  parts  of  the  plant. 

It  had  been  well  established  by  prior  decisions 
that  the  owners  were  entitled  to  a  fair  return  on 
the  fair  value  of  its  property  actually  devoted  to 
the  public  use.     "The  fair  value  of  the  property 


SUPREME  COURT  DECISIONS  71 

being  used  by  it  for  the  convenience  of  the  public." 
{Smyth  vs  Ames,  169  U.  S.  4=66, 1898.) 

That  eliminates  the  contention  of  the  Knoxville 
Water  Company  as  to  the  ''complete  depreciation," 
which  had  reference  to  property  no  longer  existing. 

The  "incomplete  depreciation"  is  disposed  of  by 
the  statement  that  it  "is  the  duty  of  the  company 
to  see  that  from  earnings  the  value  of  the  property 
invested  is  kept  unimpaired,  so  that  at  the  end  of 
any  given  term  of  years  the  original  investment 
remains  as  it  was  at  the  beginning."  Failure  to  do 
this  results  in  losses  of  value  which  are  the  fault  of 
the  company  and  must  be  borne  by  the  company. 

In  other  words  the  admitted  failure  of  the  Knox- 
ville Water  Company  to  maintain  its  property  or 
provide  for  replacement  resulted  in  loss  of  value 
that  ought  to  be  deducted.  This  was  the  case  at  bar, 
the  failure  was  actually  admitted. 

This  is  not  an  accounting  case.  It  neither  ap- 
proves nor  disapproves  of  any  method  of  account- 
ing. The  important  point  which  was  settled  by  the 
Knoxville  case  is  the  necessity  for  making  provision 
to  offset  the  wearing  out  of  plant  and  the  duty  of 
the  owner  to  secure  proper  rates  to  permit  him  to 
do  this. 

Previous  to  the  rendering  of  this  decision  the 
Supreme  Court  had  referred  to  replacement  account- 
ing methods  first  in  the  Kansas  Pacific  case  in 
October,  1878,  when  it  was  held  that  "only  such 
expenditures  as  are  actually  made  can  with  any 
propriety  be  claimed  as  a  deduction  from  earnings." 
{United  States  vs  Kansas  Pacific  Railway  Com- 


72      DEPRECIATION  OF  PUBLIC  UTILITIES 

pany,  99  U.  S.  455.)  This  in  effect  prohibited  re- 
serves for  future  replacement. 

In  Reagan  vs  Farmers'  Loan  and  Trust  Com- 
pany, 154  U.  S.  p.  362  (1894)  it  was  held  that  an 
expenditure  of  $302,085,  described  as  ''cost  of  road, 
equipment  and  permanent  improvements  "which  had 
been  charged  to  operating  expenses  was  properly 
so  charged.  A  large  part  of  it  was  for  replacement 
of  rails.  The  court  says,  "Now  it  goes  without  say- 
ing that  there  is  a  constant  wearing  out  of  rails  and 
a  constant  necessity  for  replacing  old  with  new. 
The  purchase  of  these  rails  are  what  is  necessary 
for  keeping  the  road  in  serviceable  condition." 

During  all  the  years  from  the  early  days  of  the 
industry,  down  to  1909,  the  Supreme  Court  only 
referred  to  depreciation  accounting  in  these  two 
cases  and  during  the  entire  time  railroads  had  been 
charging  replacements  direct  to  operating  expenses. 
They  have  continued  to  do  so.  This  method  is  rec- 
ognized by  the  Interstate  Commerce  Commission 
and  is  fully  authorized  by  their  classification  of 
accounts. 

In  the  Cumberland  Telephone  case,  decided  in 
February,  1909,  Justice  Peckham  delivered  the  first 
Supreme  Court  opinion  which  squarely  approved 
the  creation  of  reserves : 

"That  it  was  right  to  raise  more  money  to  pay  for  depreciation 
than  was  actually  disbursed  for  the  particular  year  there  can  be 
no  doubt,  for  a  reserve  is  necessary  in  any  business  of  this  kind." 
{Louisiana  Railroad  Commission  vs  Cumberland  Telephone  and 
Telegraph  Company,  212,  U.  S.  p.  444,  1909.) 


SUPREME  COURT  DECISIONS  73 

In  the  Lincoln  Gas  case  Justice  Lurton  sounds 
a  warning  against  double  charges  against  con- 
sumers : 

"If  in  the  past,  reconstruction  and  replacement  charges  have 
been  met  out  of  current  expenses  the  fact  must  be  taken  into 
consideration,  both  when  we  come  to  estimating  future  net 
income  and  in  determining  what  sum  shall  be  annually  set  aside 
to  guard  against  future  depreciation.  .  .  .  otherwise  there  wUI 
be  a  double  deduction  on  that  account,  first,  by  paying  such 
charges  as  they  occur,  and  thereafter  by  a  contribution  out  of  the 
remaining  income  for  the  same  object.  .  .  .  Then  the  amount  to 
be  set  aside  for  future  depreciation  will  depend  on  the  character 
and  probable  life  of  the  property  and  the  method  adopted  in  the 
past  to  preserve  the  property."  {Lincoln  Gas  and  Electric  Light 
Company  vs  City  of  Lincoln^  223  U.  S.  p.  349.)     (Italics  Ours.) 

Here  is  a  clear  recognition  of  the  propriety  of 
both  methods.  No  condemnation  of  either  one  is  to 
be  read  into  this  decision. 

The  Kansas  City  Southern  case  holds : 

"The  railroad  company  may,  if  it  sees  fit,  anticipate  general 
depreciations,  and  make  provision  for  them  by  establishing  a 
reserve  for  that  purpose,  but  if  no  such  provision  has  been  made 
the  abandonments  should  be  taken  care  of  by  charging  them  to 
present  or  future  operating  expense."  {Kansas  City  Southern  vs 
United  States,  231  U.  S.  423,  1913.) 

There  seems  to  be  no  decision  of  the  United  States 
Supreme  Court  in  recent  years  that  limits  the  ac- 
countant as  to  the  details  of  bookkeeping  methods 
to  be  adopted.  Nor  is  there  anything  inconsistent 
with  the  view  that  only  loss  of  value  in  a  property, 
whether  due  to  failure  to  maintain  the  property,  or 


74      DEPRECIATION  OF  PUBLIC  UTILITIES 

failure  to  set  up  the  proper  accounting  reserves,  is 
the  thing  that  shall  be  deducted.  We  have  up  to 
this  time  had  square  decisions  on  ''depreciation" 
from  the  Supreme  Court,  the  older  ones : 

(a)  Recognizing  the  propriety  of  accounting  for 
replacement  by  either  method. 

(b)  Demanding  that  depreciation  in  the  sense  of 
loss  of  value  shall  be  deducted. 

There  is  not  a  paragraph  in  any  of  these  decisions 
which  can  be  construed  as  demanding  the  deduction 
of  "theoretical  depreciation,"  ''accrued  service 
life"  or  any  other  arbitrary  figure  based  on  a  hypo- 
thetical comparison  of  the  existing  property  with 
an  exactly  similar  new  property.  Any  such  com- 
parison results  in  a  figure  greatly  in  excess  of  the 
sum  of  money  which  the  company  could  find  any 
justification  for  expending  on  the  property. 

The  cases  decided  in  the  period  between  Decem- 
ber, 1920  and  June  1,  1922,  go  far  toward  a  recog- 
nition of  the  fact  that  investment  may  be  "main- 
tained intact."  Judge  Knappen  of  the  United 
States  Court  of  Appeals,  Sixth  Circuit,  finds  in 
Nashville,  Chattanooga  and  St.  Louis  vs  United 
States,  269  Fed.  351  on  Dec.  6,  1920,  that  it  is  pos- 
sible so  to  maintain  a  railway  that,  after  making 
the  repairs,  renewals  and  replacements  of  a  year, 
there  has  been  no  depreciation  of  the  raihvay  "as 
a  whole."  "Also  that  it  is  possible  to  maintain  the 
roadway,  track  and  structures  so  that  there  will  be 
no  depreciation  if  we  consider  the  roadway,  track, 
and  structures  as  a  composite  whole"  also  that  "the 
service  life  of  any  normally  operated  and  normally 


SUPREME  COURT  DECISIONS  75 

and  well  maintained  railroad  is  perpetual,  and  it  is 
maintained  in  the  condition  of  property  serving  its 
purpose  by  annual  renewals  and  replacements." 

Seven  days  after  Judge  Knappen's  decision  the 
report  of  Special  Master  Abraham  S.  Gilbert  in 
New  York  and  Queens  Gas  Company  vs  Newton 
was  approved  by  Judge  Myer  (269  Fed.  277).  This 
case  was  subsequently  reviewed  by  the  United 
States  Supreme  Court  and  affirmed  on  March  6, 
1922. 

This  gives  the  Master's  report  great  weight,  to 
which  it  is  entitled  by  reason  of  his  experience.  He 
was  appointed  Master  in  eight  cases:  The  Consoli- 
dated Gas  Company,  the  New  York  and  Queens  Gas 
Company  and  in  six  other  gas  cases.  He  spent  two 
hundred  and  eighty-two  days  in  hearings  and  pre- 
paring opinions.  The  record  in  the  Consolidated 
case  was  very  large,  20,000  pages;  that  in  the 
Queens  case  2,000  pages  and  the  others  ranged  from 
1,400  to  2,900  pages. 

On  the  subject  of  Depreciation,  the  Master  held 
that  there  was  no  ascertainable  life  expectancy  on 
a  very  large  proportion  of  gas  property;  that  obso- 
lescence occurs  when  supersession  takes  place  and 
is  a  charge  on  the  economies  to  be  realized  there- 
from; that  ''the  complainant  gas  company  has  main- 
tained its  property  and  investment  intact  in  the 
past  through  renewals  and  replacements  .  .  .  and 
no  reason  appears  for  believing  that  it  cannot  con- 
tinue to  do  so,"  and  that  no  deduction  for  so-called 
** accrued  depreciation"  should  be  made. 

In  effect,  the  Galveston  case,  decided  by  Judge 


76      DEPRECIATION   OF  PUBLIC  UTILITIES 

Hutcheson  on  AprH  27,  1921  (272  Fed.  147),  holds 
that  no  depreciation  annuity  should  be  computed  on 
overhead  costs  such  as  interest  during  construction, 
organization  expense,  law  expense,  etc.,  because 
they  are  incidental  to  the  creation  of  the  property 
and  **the  property  will  not  be  constructed  again  as 
an  entirety,  but  is  to  be  kept  up  by  annual  renewals 
from  time  to  time  made,  so  that  engineering  and 
other  such  overheads,  caused  by  the  assembling  of 
the  plant,  will  not  have  to  be  provided  against,  be- 
cause they  will  not  again  be  incurred."  This  de- 
cision further  holds  that  '^ deferred  maintenance" 
is  depreciation  and  might  with  propriety  be  sub- 
tracted from  the  valuation  of  the  property. 

Justice  Brandeis  in  reviewing  this  point,  held  that 
the  request  of  the  company  to  be  allowed  to  amortize 
the  amount  of  the  deferred  maintenance  through 
an  allowance  from  earnings  over  a  five-year  period 
was  ''an  attempt,  in  another  form,  to  capitalize 
alleged  past  losses;  and  the  request  was  properly 
refused  both  by  the  master  and  the  court."  (See 
Appendix.) 

The  obligation  stated  in  the  Knoxville  case  to  see 
''that  the  value  of  the  property  invested  is  kept 
unimpaired  so  that  .  .  .  the  original  investment 
remains  as  it  was  at  the  beginning"  would  indicate 
that  the  court  had  clearly  in  mind  the  deduction 
of  such  losses  of  value  as  might  have  been  restored 
to  the  property,  but  which  had  not  been. 

The  Galveston  case  makes  it  clear  that  what  has 
been  called  "deferred  maintenance"  is  depreciation 
in  the  sense  of  loss  of  value,  that  it  is  the  duty  of 


SUPREME   COURT  DECISIONS  77 

the  company  to  maintain,  and  if  it  fails  to  do  so  it 
will  be  penalized. 

The  Appendix  is  a  fuller  review  of  the  leading  and 
historical  court  cases  bearing  on  the  subject  of  de- 
preciation. Citations  are  at  considerable  length 
and  arranged  in  chronological  order. 


CHAPTER  IX 

DIVERGENT  VIEWS  AS  TO  THE  PROPRIETY 
OF  ACCOUNTING  RESERVES 

Pkior  to  the  year  1917  there  were  two  apparently 
irreconcilable  groups,  one  arguing  for  the  creation 
of  large  reserves,  one  contending  that  such  practice 
was  not  essential. 

The  Annual  Eeport  of  President  Theodore  N. 
Vail  to  the  stockholders  of  the  American  Telephone 
and  Telegraph  Company  for  the  year  1911  presents 
one  set  of  views  as  follows : 

"While  Commissions  and  all  thorough  investigators  are  agreed 
that  provisiou  must  be  made  out  of  current  revenue  for  deprecia- 
tion and  future  replacement  of  plant,  there  seems  to  be  some 
tendency  on  the  part  of  others  to  question  any  accumulation  of 
reserves. 

"To  make  adequate  provision  for  future  contingencies  it  would 
seem  to  be  jilain  that  in  an  increasing  business  there  must  also 
be  an  increasing  reserve. 

"There  seems  to  be  a  tendency  to  insist  that  'betterment'  of 
every  character  shall  be  represented  by  capital  issue,  and  that 
depreciation  reserve  should  be  determined  with  precision,  and 
that  it,  and  all  reserves  beyond  it  represent  excessive  gross 
charges;  that  is,  gross  charges  greater  than  are  necessary  for  the 
legitimate  purposes  of  the  comiDany. 

"Reserves  are  a  provision  for  deterioration  and  obsolescence 
of  plant  beyond  that  which  can  be  covered  by  current  maintenance 

78 


DIVERGENT  VIEWS   OF   RESERVES      79 

and  current  replacements,  and  also  for  deterioration  of  assets 
and  for  fluctuations  in  gross  and  net  revenue  caused  by  varied 
business  conditions.  If  there  were  an  exactly  ascertainable  con- 
dition, with  which  all  practice  is  in  accord,  many  of  the  difficulties 
and  differences  of  opinion  connected  with  this  question  would 
disappear. 

"If  the  plant  were  kept  in  the  highest  possible  state  of  efficiency 
by  the  expenditure  of  current  revenue  for  repairs,  maintenance 
and  replacements,  sufficient  to  maintain  the  plant  at  the  highest 
possible  efficiency,  it  could  be  operated  perpetually  and  would 
never  have  to  be  replaced.  Between  this,  and  maintenance  which 
barely  keeps  the  plant  in  service,  there  is  a  wide  margin,  and  in 
this  margin  is  the  origin  of  nearly  all  the  differences  as  to  cost 
of  service,  and  in  it  is  the  opportunity  to  show  large  apparent 
profits  at  the  cost  of  the  future  of  the  plant. 

"There  are,  however,  in  the  conduct  of  business  many  condi- 
tions and  possibilities  which  cannot  be  met  out  of  current  net 
revenue  and  should  not  be  met  out  of  capital,  but  which  if  not 
provided  for  in  some  way  would  put  all  industrial  companies 
upon  a  speculative  basis. 

"There  is  that  obsolescence  which  comes  from  revolutionary 
improvements  necessitating  wholesale  replacements  of  obsolete 
apparatus  or  plant,  such  as  the  replacement  of  overhead  systems 
by  underground  systems,  or  such  as  took  place  when  the  present 
method  of  operating  was  introduced.  There  are  those  fluctuations 
in  net  revenue  caused  by  business  depression  which  cannot  be 
overcome  by  immediate  reduction  of  fixed  charges,  overhead  ex- 
penses or  operating  costs.  There  is  that  constant  tendency  to 
increase  in  wages  and  cost  of  material,  that  tendency  to  increase 
in  operating  expenses  and  capital  charges  caused  by  the  constant 
demand  for  increased  efficiency  or  service,  that  demand  for 
extensions,  productive  and  unproductive,  and  that  call  for  im- 
provements in  plant,  equipment  and  aj^paratus.  There  is  that 
increase  in  costs  of  operating,  in  greater  ratio  than  the  increase 
in  business,  peculiar  to  some  branches  of  the  telephone  service. 

"These  and  many  other  possibilities  always  confronting  indus- 
trial and  public  service  undertakings  must  be  provided  for.  They 
are  not  the  subject  of  capital   expenditures,  and  can  only  be 


80      DEPRECIATION  OF  PUBLIC  UTILITIES 

provided  for  by  an  accumulating  surplus  and  reserves  invested  in 
productive  plant  or  securities.  If .  these  are  not  provided  for, 
trouble,  if  not  disaster  or  destruction,  is  inevitable. 

"Any  practice  which  does  not,  at  the  cost  of  revenue,  pass  the 
property  on  from  the  present  to  the  future  in  at  least  as  good  a 
condition  as  received  from  the  past,  is  a  mistaken  practice;  it  is 
using  capital  for  the  benefit  of  the  present  at  the  expense  of  the 
future. 

''The  main  objections  urged  against  an  accumulating  surplus 
are  the  following: 

1.  That  it  is  provided  out  of  excessive  charges  to  the  public  for 
service. 

2.  That  it  tends  to  extravagance  of  operation,  on  the  theory 
that  close  margins  tend  to  greater  economies. 

3.  That  it  affords  a  way  of  giving  exorbitant  and  unreasonable 
dividends  to  the  shareholders  by  some  form  of  distribution  of  the 
surplus  from  time  to  time. 

"The  answer  to  the  third  objection  depends  somewhat  on  the 
treatment  and  ultimate  disposition  of  the  unappropriated  surplus 
reserves. 

"If  these  reserves  are  to  remain  as  assets  of  the  company, 
indivisible,  inviolable  and  inalienable  except  for  the  purposes 
above  mentioned,  invested  in  productive  property,  it  removes  the 
strongest  and  only  really  tangible  objection  to  surplus  of  the 
character  herein  advocated. 

"So  far  as  the  American  Telephone  and  Telegraph  Company 
and  associated  controlled  companies  are  concerned,  the  third  ob- 
jection can  be  dismissed  with  the  statement  of  their  policy,  which 
is  as  follows: 

''Except  where  in  the  extension  of  business  extraordinary  risks 
are  taken  which  entitle  them  to  some  extra  profit  in  consideration 
of  such  risks,  or  the  net  returns  have  not  been  sufficient  to  make 
an  adequate  return,  if  any,  on  the  capital,  the  American  Tele- 
phone and  Telegraph  Company  and  associated  utilities  controlled 
by  it  are  and  will  be  satisfied  with  reasonable  average  returns  on 
their  outstanding  capital  obligations,  which,  compared  with  other 
business  investments,  should  be  about  8  per  cent,  and  will  not 
expect  or  encourage  any  expectation  of  more  than  this;  and  in 


DIVERGENT  VIEWS    OF    RESERVES       81 

those  excepted  instances  above  referred  to,  they  will  only  ask  for 
that  reasonable  return  which  any  equitable  commission  or  court 
would  award  them. 

"As  to  the  second  objection.  The  most  important  and  con- 
trolling factors  of  all  charges  for  service  are  fixed  charges  and 
operating  expenses.  All  public  service  comi^anies  not  now,  will 
soon  be  under  government  control  and  regulation,  and  all  charges 
and  expenditures  will  be  under  the  close  scrutiny  of  these  reg- 
ularly constituted  bodies.  If  this  does  not  protect  against 
extravagance,  nothing  will. 

"In  answer  to  the  first  objection,  the  many  and  marked 
peculiarities  of  the  telephone  and  telegraph  as  distinguished  from 
other  public  utilities  justify  ample  surplus  reserves. 

"Any  new  railroad  or  plant  of  local  transportation  company, 
gas  or  electric  light  mains  must  be  constructed  at  least  of  a  cer- 
tain minimum  standard  or  capacity,  and  as  the  cost  of  construc- 
tion does  not  increase  in  nearly  the  same  ratio  as  the  increase  in 
capacity,  a  large  increase  of  business  is  always  provided  for  in 
the  building  of  any  new  plant.  Another  important  consideration 
in  the  size  of  plant  constructed  is  that  in  emergencies  large  over- 
loads can  be  carried  on  plants  of  this  character  for  considerable 
periods.  For  these  and  other  reasons,  additional  capital  ex- 
penditure is  not  continuous,  seldom,  if  ever,  is  imperative, 
financing  arrangements  can  be  definitely  anticipated  for  long 
periods  and  adapted  to  the  most  favorable  conditions  and  times. 

"With  the  telephone  and  telegraph,  the  case  is  entirely  different. 
Except  below  relatively  small  minimum  units,  the  telephone  plant 
is  built  according  to  the  business  that  is  expected  in  the  immediate 
future,  and  the  plant  necessary  for  the  development  of  business 
can  be  added  as  needed,  and  to  save  charges  on  idle  plant  this 
is  done.  It  is  sometimes  advantageous  to  anticipate  growth,  and 
it  is  often  but  only  done  when  the  saving  in  construction  costs 
and  other  advantages  more  than  balance  the  cost  of  carrying  the 
idle  plant.  There  can  be  no  overload  in  the  telephone  business, 
the  capacity  of  the  plant  must  be  equal  to  the  peak  of  the 
business  and  to  all  possible  emergencies.  Each  increase  in  busi- 
ness calls  for  an  additional  telephone  circuit  and  each  telephone 
circuit  calls  for  additional  capital  expenditure,  and  under  the 


82      DEPRECIATION   OF   PUBLIC   UTILITIES 

requirements  of  the  business  all  demands  for  extension  of  service 
are  imperative  and  must  be  met  at  once. 

"This  make  necessary  regular  periodical  provisions  for  finan- 
■cing,  which  must  be  met  regardless  of  the  general  business  con- 
ditions. 

"Another  and  a  marked  disadvantage  of  the  telephone  business 
as  compared  with  other  public  services  is  that  the  capital  ex- 
penditure for  gas  or  electric  light  plant  is  confined  to  generating 
plant  and  distributing  mains;  the  customer's  connection  from 
street  to  house  and  the  inside  house  installation  are  done  with 
the  capital  and  at  the  cost  of  the  customer. 

"With  the  telephone  each  additional  subscriber  calls  for  capital 
expenditure  from  the  central  office  to  the  house  or  place  of  busi- 
ness, and  for  all  interior  installation  and  wiring.  This  interior 
installation,  representing  large  expenditure,  is  a  burden  not  only 
on  the  capital  but  on  the  net  revenue  of  the  telephone,  from  which 
other  service  companies  are  free.  For  every  one  hundred  thou- 
sand stations  gained  in  1911,  two  hundred  and  seventy-two 
thousand  stations  were  installed.  All  the  cost  of  the  one  hundred 
and  seventy-two  thousand,  over  and  above  the  salvage,  which  is 
variable  and  small  at  best,  is  a  charge  upon  revenue,  and  a  gen- 
eral charge  on  all  permanent  subscribers,  which  would  not  be  the 
case  if  the  interior  installation  were  at  the  expense  of  the  sub- 
scriber. 

''All  the  advantages  of  an  unexpended  surplus  reserve,  which 
remains  invested  in  an  inalienable  asset  of  the  company,  namely 
in  productive  plant,  accrue  to  the  public  by  the  reduction  of 
revenue  which  it  is  not  necessary  to  earn  to  meet  the  capital 
charges,  as  the  plant  which  is  constructed  out  of  these  surplus 
reser\-es  does  not  represent  capitalization. 

"Among  the  more  important  advantages  to  a  company  of  a 
large  surplus  represented  in  the  fixed  assets  are  the  following: 

"It  strengthens  the  company's  credit,  enabling  the  company 
to  make  its  interest  and  dividend  payments  uniform  and  depend- 
able. 

"It  enables  the  company  on  the  strength  of  this  credit  to 
obtain  its  capital  requirements  on  the  most  favorable  terms. 


DIVERGENT  VIEWS   OF   RESERVES      83 

"It  enables  the  company  to  ride  out  commercial  and  financial 
disturbances  which  might  otherwise  cripple  or  destroy  it. 

"It  enables  the  company  to  maintain  at  all  times  the  highest 
state  of  efficiency  in  its  operation,  which  would  be  impossible  for 
any  company  which  is  obliged  to  adjust  its  more  or  less  inflexible 
operating  expenses  to  the  constant  and  inevitable  fluctuations  of 
business. 

"It  is  a  reservoir,  as  it  were,  which,  supplied  by  a  fluctuating 
stream  of  gross  revenue,  enables  the  company  to  maintain  even 
and  uniform  disbursement  for  service,  maintain  a  uniform  oper- 
ating organization,  and  that  high  state  of  efficiency  which  can 
result  only  from  a  permanent  operating  force. 

"To  reduce  rates  as  fast  as  any  surplus  is  created,  to  forbid 
any  application  of  revenue  to  the  betterment  of  plant,  to  insist 
that  new  capital  shall  be  provided  for  such  purposes,  would 
never  be  thought  of  in  any  private  business  and  should  not  in 
any  corporate  business,  particularly  public  utilities,  subject  to 
other  regulation  and  control  than  that  of  actual  ownership.  In 
individual  or  partnership  business  all  revenue  beyond  stipulated 
amounts  is  left  in  the  business,  is  a  reserve,  and  in  addition  there 
is  that  reserve  consisting  of  the  entire  assets  of  the  individual. 
This  is  the  basis  of  business  credits. 

"The  only  sound  conclusion  that  can  be  reached  after  full  con- 
sideration of  all  the  various  phases  and  factors  of  the  problem 
is,  that  ample  reserves  should  be  provided  to  meet  not  only  prob- 
able happenings  but  possible  happenings,  and  that  such  reserves 
should  be  so  invested  that  whatever  increment  or  revenue  is  to  be 
derived  from  the  amounts  unexpended  or  not  used  for  the  pur- 
poses intended  will  go  to  the  public  in  reduction  of  charges  for 
or  in  improvement  of,  service,  and  that  the  value  of  a  public 
utility  plant  should  be  represented  by  a  relatively  small  per- 
centage of  outstanding  securities  calling  for  fixed  charges. 

"No  expenditure  which  does  not  produce  increased  net  revenue 
should  be  capitalized. 

"Any  public  service  plant  which  is  represented  by  relatively 
small  outstanding  capital  obligations  is  stronger,  can  better  meet 
its  public  obligations,  and  so  long  as  the  surplus  is  inviolable  and 
inalienable  as  above  defined,  and  the  company  under  government 


84      DEPRECIATION   OF  PUBLIC  UTILITIES 

control  and  regulation,  the  greater  the  ratio  of  surplus  and 
reserves  to  plant,  the  nearer  we  get  to  all  the  supposed  ad- 
vantages of  public  ownership  without  any  of  its  risks,  while 
retaining  all  the  advantages  of  private  management." 

In  1914  Mr.  Vail  commented  as  follows  on  this 
subject : 

"The  policy  of  the  Bell  System  with  respect  to  depreciation 
and  depreciation  reserve  has  continued  on  lines  that  are  recog- 
nized as  sound  and  reasonable  both  by  investors  and  by  the  tele- 
phone-using public. 

"That  policy,  briefly  stated,  is  this:  Each  Bell  Company  makes 
charges  to  its  operating  expenses  for  the  purjDose  of  creating  and 
maintaining  proper  and  adequate  depreciation  reserves,  and  these 
reserves  are  used  to  meet  the  expense  of  depreciation. 

"The  Interstate  Commerce  Commission  defines  expense  of  de^ 
preciation  as  follows : 

"(a)  The  losses  suffered  through  the  current  lessening  in  value 
of  tangible  property  from  wear  and  tear  (not  covered  by  current 
repairs). 

"(b)  Obsolescence  or  inadequacy  resulting  from  age,  physical 
change,  or  supersession  by  reason  of  new  inventions  and  dis- 
coveries, changes  in  popular  demand,  or  public  requirements,  and 

"(c)  Losses  suffered  through  destruction  of  property  by  extra- 
ordinary casualties. 

"The  amount  charged  by  the  Bell  Companies  for  depreciation 
in  1914  was  over  $41,000,000,  of  which  the  amount  unused  during 
the  year  was  about  $15,000,000.  While  this  $15,000,000  will  some 
day  be  required  for  replacement  of  plant,  it  does  not  remain 
idle  in  the  meantime,  but  is  invested  in  productive  plant,  and  ia 
thus  temporarily  employed  as  additional  capital  on  which  no 
dividends  or  interest  charges  have  to  be  paid." 

This  company  has  throughout  its  history  con- 
sistently followed  the  policy  outlined  by  Mr.  Vail  in 


DIVERGENT   VIEWS   OF   RESERVES      85 

the  two  annual  reports  which  have  been  quoted  in 
full  as  far  as  they  refer  to  this  subject. 

The  following  figures  taken  from  the  annual  re- 
ports of  the  company  show  the  results  of  this  policy : 

Bell  Telephone  System  in  the  United  States 

Statistics  derived  from  statements  of  earnings  and  expenses  as 
published  in  annual  reports  1911  to  1917  inclusive.  All  duplications 
excluded. 


(1) 

(2) 

(3) 

(4) 

(5) 

(6) 

(7) 

Year 

Gross 
Earnings 

Current 
Mainte- 
nance 

Deprecia- 
tion 

Total  Net 
Earnings 

Dividends 
Paid 

Surplus 

$ 

$ 

$ 

$ 

S 

$ 

1910 

165,612,881 

25,763,082 

26,264,927 

50,994,408 

25,160,786 

14,276,758 

1911 

179,477,998 

30,184,522 

28,655,832 

51,586,297 

25,966,876 

12,008,561 

1912 

199,172,154 

31,762,636 

34,942,802 

56,886,690 

29,460,215 

13,221,110 

1913 

215,572,822 

32,442,979 

37,739,991 

58,689,523 

30,301,705 

11,735,194 

1914 

225,952.123 

31,595,388 

41,496,240 

59,247,279 

30,304,186 

10,002,452 

1915 

239,909,649 

31,171,272 

44,888,702 

66,181,757 

32,897,065 

15,189,049 

1916 

*264,575,280 

34,923,549 

49,631,966 

t88,669,675 

35,160,119 

22,078,589 

1917 

*294,894,950 

41,151,041 

52,919,458 

t90,488,806 

36,862,582 

13,851,629 

Total . 

1,785,167,857 

258,994,469 

316,539,918 

522,744,435 

246,113,534 

112,363,342 

Accounting  changed,  Jan.  1,  1916. 

*  Gross  income  from  operation,  not  exactly  comparable  with  prior  years. 

t  Total  net  income,  not  exactly  comparable  with  prior  years. 

Reference  to  the  balance  sheets  shows  total  re- 
serves, surplus  and  depreciation  of  $119,598,526  in 
1910  which  had  increased  to  $303,525,651  by  Dec.  31, 
1917. 

During  this  same  period  the  book  valuation  of 
telephone  plant  increased  from  $610,999,964  to 
$1,064,892,710.  The  period  of  government  control 
in  1918  and  1919  has  left  the  reports  for  these  years 
such  that  it  is  considered  advisable  to  include  no 
figures  subsequent  to  the  year  1917. 


86      DEPRECIATION  OF  PUBLIC  UTILITIES 

During  the  entire  period  of  8  years  from  1910 
to  1917  the  accumulation  for  depreciation  reserves 
averaged  17.7  per  cent  of  earnings,  or  an  annual 
charge  of  between  4  and  5  per  cent  of  the  book 
value. 

Analysis  of  these  figures  would  appear  to  indicate 
that  $503,970,604  had  been  expended  in  maintenance 
and  replacements  from  Column  3  and  Column  4,  and 
that  over  $71,500,000  from  the  depreciation  had  with 
the  surplus  gone  to  make  up  the  increase  of  $183,- 
927,125  of  balance  sheet  surplus. 

These  figures  are  given  as  being  perhaps  as  good 
an  illustration  as  can  be  found  of  the  results  of 
modem  depreciation  accounting  and  would  go  to 
prove  that  the  company  is  doing  exactly  what  their 
statements  indicate  they  have  set  out  to  do. 

From  the  standpoint  of  conservative  business 
which  secures  rates  sufficient  fully  to  protect  the 
investor,  this  is  an  ideal  showing. 

There  is  another  group  of  men  who  contend  that 
this  form  of  accounting  is  neither  necessary  nor 
especially  desirable.  Professor  Allyn  A.  Young  in 
a  paper  entitled  ''Depreciation  and  Eate  Control"^ 
says: 

"Moreover,  it  would  now  be  idle  to  claim  that  to  require 
depreciation  charges  is  in  no  manner  to  interfere  with  the  finan- 
cial policy  of  the  railroads.  For  the  compulsory  annual  additions 
to  the  reserve  for  accrued  depreciation  decrease  by  their  full 
amount  the  apparent  profits  of  the  year  and  thus  the  amount 
available  for  dividends.  Although  no  investment  of  a  separate 
depreciation  fund  is  required,  yet  the  writing  down  of  the  capital 

^  Quarterly  Journal  of  Economics,     August,  1914. 


DIVERGENT  VIEWS  OF   RESERVES      87 

assets  by  the  amount  of  the  accrued  'depreciation'  means  in  the 
long  run  either  that  other  assets  have  to  be  larger  in  amount 
than  they  otherwise  would  have  been  or  that  liabilities  have  to  be 
smaller.  Usually  the  growth  of  the  reserve  for  accrued  deprecia- 
tion means  in  practice  that  additional  permanent  investments  are 
being  made  out  of  earnings.  The  reserve  represents  an  additional, 
permanent,  and  compulsory  investment  in  the  business  to  take  the 
place  of  the  amount  of  the  investment  written  off  for  deprecia- 
tion. To  require  such  a  reserve  to  be  created  is  to  control,  in  that 
degree,  the  financial  policies  of  the  companies  affected.  This  is 
not  to  condemn  the  requirement  in  question,  but  merely  to  show 
its  real  significance. 

''But,  it  may  be  objected,  surely  property  that  is  half  worn 
out  is  not  worth  as  much  as  when  it  was  new.  Should  not  its 
value  be  written  down,  if  the  balance  sheets  are  to  tell  the  truth? 
This  question  has  significance  only  if  it  be  assumed  that  the 
purpose  of  the  depreciation  accounts  of  railroads  and  other  public 
service  companies  is  to  record  the  decline  in  the  market  value 
of  individual  assets.  But  even  for  private  business  undertakings 
this  is  not,  in  the  opinion  of  the  majority  of  competent  writers, 
the  purpose  of  depreciation  accounts.  It  is  most  certainly  not 
their  purpose  in  railroad  and  public  utility  accounting. 

"The  balance  sheets  of  public  service  corporations  are  not 
designed,  as  those  of  a  merchant  might  be,  with  primary  reference 
to  a  possible  insolvency.  The  outlook  to  be  assumed  is  that  of 
continuous  and  permanent  operation.  Many  of  the  parts  of  a 
public  service  property  could  not  be  detached  and  sold  except  as 
scrap.  And  as  for  the  market  value  of  the  undertaking  as  a 
whole,  it  is  scarcely  necessary  to  say  that  this  is  a  matter  of 
earning  power,  which  depends  upon  rates  and  hence  eventually 
upon  the  manner  in  which  public  control  is  exercised.  It  is 
hardly  to  be  expected  that  anyone  will  defend  the  propriety  of  a 
reserve  against  the  possible  depreciation  of  market  values  result- 
ing from  compulsory  rate  reductions. 

"Nor  are  the  depreciation  charges  on  public  service  properties 
supposed  in  any  way  to  represent  a  diminution  of  the  productive 
eflBciency  of  the  plant  and  equipment.  For  with  replacements 
and  repairs  properly  attended  to,  there  is  no  general  decline  in 


88      DEPRECIATION  OF  PUBLIC  UTILITIES 

productive  efficiency.  Even  for  any  individual  item  among  the 
wasting  assets  the  loss  of  productive  efficiency  usually  comes  as 
a  sharp  decline  near  the  end  of  its  period  of  life  rather  than  a 
gradual  deterioration  spread  evenly  through  its  years  of  use. 

"The  depreciation  to  be  reckoned  with  in  the  ease  of  such 
properties  is  merely  a  phase  of  cost-keeping — a  device  for 
allocating  the  consumption  of  capital  among  the  successive  years. 
The  concrete  facts  to  be  recorded  as  best  they  may  are  not  the 
'using  up  of  values'  (whatever  that  may  mean)  nor  yet  anything 
related  to  a  deterioration  in  the  service  rendered,  but  merely  the 
actual  expiration  of  part  of  the  aggregate  probable  period  of  use 
of  the  instruments  of  production  on  hand,  and  the  nearer  ap- 
proach of  the  time  when  they  will  have  to  be  replaced. 

"Profits  and  interest,  it  is  very  certain,  cannot  be  counted  until 
the  principal  of  an  investment  is  replaced  or  provision  is  made 
for  its  replacement.  In  the  case  of  a  business  where  one  item 
forms  the  bulk  of  the  income-yielding  assets — a  steamship,  a  coal 
mine,  a  patent  right  purchased  at  a  price,  for  example — either 
enough  must  be  set  aside  out  of  annual  earnings  to  replace  the 
original  cost  of  the  property  when  it  is  abandoned  or  retired,  or 
the  proprietors  must  be  content  to  consider  that  their  investment 
is  being  returned  to  them  in  instalments.  If  the  business  is  to 
be  continued  on  the  same  scale  the  replacement  must,  of  course, 
be  provided  for  in  advance  or  else  the  proprietors  must  make  a 
second  investment  equal  in  amount  to  the  first. 

"All  this  is  elementary.  It  is  brought  into  the  present  discus- 
sion merely  to  indicate  clearly  the  conditions  under  which  a 
reserve  for  accrued  depreciation  is  well-nigh  indispensable.  But 
where  a  property  is  varied  and  no  single  wasting  asset  or  group 
of  such  assets  is  of  dominating  importance  the  case  has  been 
shown  to  be  different.  The  periods  of  use  of  the  different  items 
of  assets  overlap,  so  that  when  depreciation  is  charged  from  the 
beginning  on  each  item,  a  reserve  begins  to  accrue  on  a  given 
item  before  the  reserves  accumulated  on  account  of  other  items 
have  been  diminished  on  account  of  replacements.  The  per- 
manent reserve  thus  created  is  not  needed.  Nothing  correspond- 
ing to  it  appears  in  the  simpler  case  where  depreciation  is  regis- 
tered on  some  large  asset  representing  the  major  part  of  the 


DIVERGENT   VIEWS  OF   RESERVES      89 

investment.  It  is  very  likely  that  some  of  its  defenders  fail  to 
distinguish  between  depreciation  charges  to  provide  for  replace- 
ment and  depreciation  to  provide  for  liquidation — i.e.,  to  maintain 
market  value. 

"The  fallacy  in  the  view  that  the  'reserve  for  accrued  deprecia- 
tion' is  a  necessary  record  of  fact  hinges  on  what  is  from  the 
economic  point  of  view  the  more  or  less  accidental  circumstance 
that  the  productive  equij^ment  of  an  undertaking  happens  to  be 
in  units  of  a  sort  that  are  defined  as  units  by  the  customary 
categories  of  purchase  and  sale.  In  economic  fact  the  property 
of  a  public  service  undertaking  as  a  whole  is  a  productive  unit. 
Consider  it  as  such — then  replacements  appear  merely  as  repairs 
necessary  to  keep  the  whole  property  in  a  state  of  efficiency. 
Repairs  in  this  large  sense  are  of  course  to  be  counted  as  oper- 
ating expenses,  as  is  true  of  minor  repairs.  But  if  such  repairs 
are  fairly  regular  in  amount  year  by  year  there  ajopears  to  be  no 
inexorable  reason  why  a  fund  to  provide  for  them  should  be 
accumulated  in  advance  and  more  especially  a  fund  that  will 
amount  to  much  more  than  the  actual  annual  cost  of  the 
repairs.  .  .  ." 

"In  general,  there  is  a  reasonable  presumption  that  the  invest- 
ments in  undertakings  which  have  not  accumulated  a  depreciation 
reserve  were  not  made  with  the  expectation  that  it  would  be 
necessary  to  charge  depreciation  accruals  to  operating  expenses. 
It  follows  that  it  cannot  in  general  be  presumed  that  the  profits 
of  such  undertakings  have  contained  an  element  which  should 
unquestionably  be  considered  a  repayment  of  part  of  the  invested 
principal.  Accordingly,  serious  objection  might  properly  be 
made  to  a  system  of  compulsory  accounts  which  requires  that 
property  already  on  hand  be  written  down  for  depreciation. 

"The  control  of  accounting  with  respect  to  property  acquired 
after  the  new  system  of  accounts  is  introduced  is  quite  another 
matter.  These  subsequent  investments  (including  replacements) 
are  made  with  full  knowledge  of  the  accounting  rules  in  force  and 
of  the  way  in  which  'profits'  are  to  be  defined  and  measured. 
Whether  a  'reserve  for  accrued  depreciation'  should  be  required 
for  such  property  is  purely  a  matter  of  public  policy.  They  are 
not  necessary  to  the  continued  and  successful  operation  of  the 


90      DEPRECIATION  OF  PUBLIC  UTILITIES 

property.  But  there  are  several  points  in  their  favor.  Such 
inequalities  as  occur  in  the  rsplacement  needs  of  successive  years 
can  be  met  with  less  shock.  Annual  profits  tend  to  remain 
steadier  when  variations  in  replacements  are  largely  absorbed  by 
the  variation  of  corresponding  charges  to  the  depreciation  account 
rather  than  being  directly  charged  to  current  operating  expenses. 
And  in  the  case  of  possible  purchase  at  some  future  time  by  the 
government  the  existence  of  adequate  reserves  against  all  accrued 
depreciation  would  greatly  simplify  the  problem  of  valuation  for 
sale,  just  as  it  would  eliminate  some  of  the  difficulties  that  now 
attend  the  problem  of  valuation  of  rate  control." 

Eobert  A.  Carter  and  William  L.  Ransom  in  1921, 
made  a  clear  statement  of  the  case  in  connection 
with  a  discussion  of  the  reserves  of  Class  I  railways 
and  of  the  New  York  Telephone  Company : 

"Whether  the  rates  charged  by  the  telephone  company  or  by  the 
midway  carriers  are  or  were  reasonable  or  excessive,  we  do  not 
undertake  to  say.  That  question  is  for  the  regulatory  commis- 
sions charged  with  the  duty  of  seeing  to  it  that  such  rates  are 
kept  neither  too  high  nor  too  low.  Our  comments  are  only  upon 
a  system  of  accruals  through  charges  to  operating  expenses  on 
the  basis  of  theoretical  estimates,  which  leads  to  the  collection  of 
sums  so  greatly  in  excess  of  the  actual  retirement  expense  over  a 
representative  period.  Whether  the  rates  actually  charged  yielded 
more  than  a  fair  return  over  and  above  actual  operating  expenses, 
we  do  not  here  discuss.  Any  sums  collected  in  excess  of  actual 
operating  costs,  including  the  actual  retirement  expenses  (aver- 
aged, if  desired,  over  a  representative  period)  should  be  collected 
as  return  on  investment  or  not  at  all.  No  carrier  or  utility  should 
be  permitted  to  collect  from  its  patrons  more  than  its  operating 
expenses  plus  a  fair  return,  and  no  carrier  or  utility  should  be 
permitted  to  make  its  return  from  existing  rates  appear  in- 
adequate through  charging  to  operating  expenses  a  sum  whose 
accrual  is  not  required  by  any  actual  outlays  of  the  company, 
either  current  or  prospective.    No  implication  is  intended  to  be 


DIVERGENT  VIEWS   OF  RESERVES      91 

conveyed  against  the  policy  of  making  reserves,  out  of  the  fair 
return,  for  contingencies,  if  it  is  deemed  advisable  to  thus  segre- 
gate a  part  of  the  sur^olus  earnings.  There  should  be  left,  how- 
ever, no  room  for  doubt  that  when  thus  segregated  such  a  reserve 
still  represents  surplus  earnings  belonging  to  the  stockholders 
and  that  upon  the  property  in  which  it  is  invested  the  company 
lias  as  unquestionable  a  right  to  earn  a  fair  return  as  it  has  upon 
the  property  representing  its  surplus  so  called." 

That  courts  are  beginning  to  take  notice  of  the 
fact  that  the  creation  of  reserves  may  have  to  be 
restricted,  is  evident  from  some  of  the  later  cases. 
This  subject  is  discussed  in  Pioneer  Telephone  and 
Telegraph  Company  vs  State,  an  Oklahoma  case, 
by  the  Supreme  Court  of  that  state  in  September, 
1917.  This  case  is  reported  in  167  Pac.  995.  In 
the  decision  Judge  Kane  expressed  the  views  of  the 
court  as  follows: 

''From  our  investigation  of  the  problem  of  depreciation  we  are 
convinced  that  precedent  on  this  question  is  varying,  and  that 
there  is  also  great  contrariety  of  opinion  among  the  heads  of 
public  service  corporations  themselves,  some  companies  believing 
that  their  best  interests  lie  in  adopting  the  largest  possible  de- 
preciation charge  and  in  the  consequent  accumulation  of  a  per- 
manent fund  in  the  future,  whilst  others  contend  that  the  applica- 
tion of  the  doctrine  amounts  to  a  virtual  confiscation  of  their 
property.  Without  attempting  to  set  out  herein  our  analysis  of 
these  discordant  views,  it  is  sufficient  to  say  that  we  have  reached 
the  conclusion  that  in  plants  of  considerable  size  that  have  at- 
tained their  gait,  to  which  class  the  plant  herein  is  conceded  to 
belong,  there  is  both  theoretically  and  actually  a  normal  condi- 
tion in  which  the  replacements  come  along  with  comparative 
evenness,  and  where  there  can  be  no  possible  use  for  a  so-called 
depreciation  fund  of  any  considerable  amount." 

"There  is  no  principle  of  public  regulation  more  firmly  estab- 


92      DEPRECIATION  OF  PUBLIC  UTILITIES 

lished  than  the  right  of  the  company  to  charge  in  its  rate  an 
amount  which  will  enable  it  to  make  these  replacements,  and  as 
investors  put  their  money  into  public  utilities  for  the  sake  of  the 
returns  they  will  be  able  to  obtain,  if  the  allowance  for  replace- 
ments is  sufficient  to  keep  up  a  high  degree  of  efficiency  and  pre- 
vent a  lowering  of  the  ability  of  the  plant  to  earn  returns,  we 
are  unable  to  perceive  the  necessity  for  building  up  a  fund  to  be 
used  for  the  purpose  of  counteracting  a  purely  theoretical  depre- 
ciation. The  theory  of  the  Commission  seems  to  be  that  charges 
should  be  made  in  rates  sufficient  to  counteract  or  prevent  de- 
preciation by  replacements,  and  that  when  replacements  are  thus 
fully  provided  for,  depreciation  is  counteracted." 

The  presentation  of  these  opposing  views  has 
been  quoted  at  considerable  length  on  account  of 
the  clarity  of  the  arguments  presented  and  the  ex- 
tremely high  standing  of  the  men  making  them. 

It  should  be  emphasized  that  there  is  great  di- 
vergence of  opinion  on  this  particular  subject,  that 
it  is  so  possible  to  administer  depreciation  reserve 
accounting  as  to  be  wholly  in  the  interest  of  the 
owner  and  as  to  work  a  great  hardship  or  injustice 
to  the  consumer,  and  that  it  is  a  subject  which  may 
cause  a  vast  amount  of  difficult  and  delicate  work 
for  regulating  commissions  in  the  future  if  methods 
are  approved  now  which  later  may  need  to  be  re- 
vised in  the  interest  of  the  consumer  or  rate  payer. 


CHAPTER  X 

THE  UNCERTAIN  CHARACTER  OF 
DEPRECIATION  ESTIMATES 

Whenever  it  becomes  necessary  to  make  allow- 
ances for  replacement  and  to  create  reserves  for 
replacement  it  becomes  necessary  for  someone  to 
make  estimates  of  the  annual  decretion  or  loss  of 
service  life  of  the  property,  over  and  beyond  re- 
placements charged  to  operating  expenses  during 
the  year. 

Too  much  stress  cannot  be  laid  upon  the  uncertain 
and  approximate  character  of  all  such  estimates. 

It  is  fair  to  assume  that  in  every  case  the  ac- 
countants will  make  use  of  the  best  information 
available  on  which  to  base  judgment,  but  there  are 
many  factors  which  enter  to  complicate  the  esti- 
mates. 

The  size  of  the  property  has  much  to  do  with  the 
extent  of  detail  which  can  be  undertaken  in  account- 
ing. On  a  comparatively  small  property,  especially 
where  there  is  not  rapid  expansion,  it  may  be  en- 
tirely practicable  to  use  an  amount  of  detail  which 
would  not  be  possible  on  a  large  property  covering 
a  great  area  of  country  or  doing  business  in  a  large 
city,  in  several  cities  or  in  more  than  one  state. 

93 


94      DEPRECIATION  OF   PUBLIC  UTILITIES 

The  size  and  character  of  the  accounting  organ- 
ization has  a  decided  influence  on  accuracy  of  detail. 
Where  the  property  is  such  that  a  few  people  who 
have  a  familiarity  with  the  physical  property  are 
the  only  ones  who  handle  the  accounts,  the  results 
are  likely  to  be  very  different  from  those  secured 
by  an  organization  with  several  hundred  employees, 
possibly  in  several  offices,  in  different  localities,  all 
of  whom  are  called  upon  to  do  some  part  of  the 
work.  Changing  personnel,  lack  of  familiarity  with 
the  physical  details  of  the  plant,  dependence  on  the 
opinion  of  men  not  familiar  with  the  accounting 
methods  employed,  all  are  things  to  be  reckoned 
with. 

This  subject  is  discussed  by  Hooper  in  **  Railroad 
Accounting"  (1915)  as  follows: 

"There  are  two  other  important  things  which  must  be  allowed 
for  in  considering  the  cost  of  upkeep  of  the  plant.  These  are 
depreciation  and  the  treatment  of  abandonment  of  property.  If 
a  factory  building  is  subjected  to  wear  and  tear  of  machinery 
that  will,  in  the  course  of  a  certain  number  of  years,  entirely 
destroy  it,  regardless  of  the  fact  that  repairs  are  made  during 
these  years,  there  is  an  item  of  expense  going  on  in  each  one  of 
these  years  that  is  not  being  covered  by  the  charges  for  repairs. 
If  at  the  end  of  the  series  of  years  the  building  is  replaced  with 
a  new  building,  the  charge  for  this  replacement  is  not  an  addi- 
tional investment  in  property  but  is  an  expense  of  doing  business. 
If,  however,  the  entire  cost  of  replacing  the  building  is  charged 
to  the  expenses  of  the  single  year  in  which  the  replacement  takes 
place,  in  theory  at  least  an  undue  charge  is  made  against  the 
revenues  of  that  particular  year.  The  deterioration  of  the  build- 
ing has  taken  place  in  each  year  during  the  series.  It  is  in  recog- 
nition of  this  fact  that  industrial  companies  make  a  certain 
charge  each  year  in  addition  to  expenses  for  what  is  called  depre- 


UNCERTAINTY  OF  DEPRECIATION      95 

ciation.  Depreciation  on  a  factory  building  is  comparatively 
easy  to  figure,  but  when  one  tries  to  figure  dejjreciation  on  such 
a  highly  complicated  plant  as  that  used  by  a  railroad  company  in 
the  manufacture  of  transportation,  the  task  becomes  well-nigh 
impossible.  Even  if  it  were  possible  to  have  a  list  of  every  class 
of  material  that  forms  part  of  the  permanent  way  and  structures 
of  a  railroad,  and  from  long  observation  to  be  able  to  tell  with  a 
fair  degree  of  accuracy  what  the  life  of  each  class  of  material 
was,  the  rates  of  depreciation  would  be  so  varied,  not  only  as 
between  different  classes  of  material  but  as  between  the  same 
materials  used  under  different  service  and  weather  conditions,  that 
any  rate  for  the  whole  plant  would  be  hopelessly  wide  of  the 
facts.  The  same  would  be  true  for  any  unit  selected,  as,  for 
instance,  road  mile  or  track  mile.  The  Interstate  Commerce  Com- 
mission permits  railroad  companies  to  charge  as  part  of  expenses 
depreciation  on  roadway  and  structures  if  they  so  desire,  but 
makes  no  suggestions  as  to  how  this  depreciation  shall  be  figured." 

*'An  arbitrary  charge  of  this  kind  is  worse  than  no  charge  at 
all,  because  one  of  the  greatest  benefits  resulting  from  the  exercise 
of  the  power  of  the  commission  to  prescribe  accounts  has  been  the 
uniformity  that  has  necessarily  been  adopted  in  keeping  the 
accounts.  A  charge  for  depreciation  is  in  the  nature  of  a  'guess' 
at  the  life  of  equipment  and  'guessing'  is  not  the  province  of  an 
accountant." 

"The  management  of  a  railroad  company  is  very  human. 
There  is  no  scientific  basis  on  which  a  roadmaster  can  certify  to 
the  management  the  exact  day,  month,  or  even  year  in  which  a 
tie  or  a  rail  needs  renewal;  the  same  is  true  as  to  ballast  and 
other  material.  There  is  no  scientific  rule  by  which  a  man  can 
tell  when  he  needs  a  new  suit.  If  he  is  making  money  he  decides 
that  his  old  suit  can't  possibly  be  used  for  another  season  and 
he  orders  a  new  one ;  if  he  is  in  hard  luck,  the  old  suit  is  plenty 
good  enough  for  another  season.  Railroads  are  run  on  much  the 
same  basis.  Cars  and  locomotives  can  be  kept  in  service  for  a 
long  time  if  the  road  cannot  afford  to  replace  them.  In  other 
words,  the  commission's  system  of  accounts  does  not  prevent  a 
management  from  either  starving  or  fattening  up  the  property." 


96      DEPRECIATION   OF   PUBLIC   UTILITIES 

The  more  one  investigates  accounting  discussions 
of  this  subject  the  more  completely  one  is  convinced 
of  its  difficulties  and  complexities  and  of  the  fact 
that  only  men  of  long  experience  in  accounting  and 
possessing  an  exceptional  acquaintance  with  the 
property  and  knowledge  of  its  various  parts  ought 
to  be  in  charge  of  this  work. 

When  faced  with  the  task  of  making  an  estimate 
of  the  actual  depreciation  or  loss  of  value  which 
has  accrued  in  a  property,  which  should  be  deducted 
on  account  of  failure  of  the  owners  to  "maintain 
the  investment  intact,"  the  engineer  is  compelled  to 
resort  to  some  form  of  computation  on  which  to  base 
his  estimate. 

In  the  same  way  the  accountant  must  adopt  some 
basis  for  the  determination  of  that  allowance  which 
he  will  make  to  offset  the  wear  and  tear,  obsoles- 
cence and  decay  of  the  current  year  which  cannot 
be  made  good  by  replacement  of  parts. 

Naturally  both  engineer  and  accountant  have 
turned  to  the  average  life  of  certain  classes  of  prop- 
erty as  one  method  which  appears  to  be  reasonable. 
In  the  case  of  the  life  insurance  companies  tables 
have  been  prepared  giving  the  expectancy  of  hu- 
man life.  These  tables  are  based  on  the  experience 
of  many  years,  and  rest  on  vital  statistics  which 
have  been  carefully  kept.  They  deal  with  hundreds 
of  thousands  or  perhaps  millions  of  individuals. 
These  tables,  supplemented  by  a  most  careful  phys- 
ical examination  of  the  individual,  form  a  basis  for 
an  estimate  of  remaining  life.  In  referring  to  this 
illustration  it  must  be  remembered  that  each  human 


UNCERTAINTY   OF  DEPRECIATION       97 

unit  is  given  a  medical  examination  that  is  much 
more  thorough  than  the  engineering  examination 
which  is  ever  given  to  physical  property  by  either 
engineer  or  accountant. 

The  engineer  and  the  accountant  have  the  benefit 
of  no  such  statistics  or  no  such  life  tables  applying 
to  property  as  are  the  insurance  companies'  human 
life  tables.  Certain  units  of  property  are  not 
greatly  subject  to  wear  and  tear,  but  reach  the  end 
of  their  usefulness  on  account  of  decay.  Some  kinds 
of  timber  under  given  conditions  may  have  a  fairly 
determinable  life.  For  example,  a  railroad  forty  or 
fifty  years  old  may  have  reasonably  dependable 
records  of  the  average  life  of  ties  or  of  bridge  or 
trestle  timber  so  that  these  records  may  form  a  good 
basis  for  estimating. 

If  all  available  statistics  as  to  locomotives  were 
to  be  collected  and  analyzed  it  is  quite  possible  that 
some  definite  conclusions  could  be  drawn.  This  class 
of  property  is  made  up  of  large  units  whose  cost 
is  known,  and  frequently,  perhaps  generally,  indi- 
vidual records  are  kept  with  each  locomotive,  show- 
ing the  cost  of  each  repairing  and  major  overhaul- 
ing. There  are  few  kinds  of  physical  property  of 
which  this  is  true. 

Some  kinds  of  property  have  a  life  which  is  not 
properly  measureable  in  years.  The  rail  on  the 
main  line  of  a  heavy  traffic  road  wears  out  and  its 
life  is  measurable  in  terms  of  the  number  of  loco- 
motive miles  or  ton  miles  passing  over  it.  Rail  of 
the  same  weight  and  chemical  composition  will  have 
a  life  of  two  or  three  years  on  one  road,  twenty 


98      DEPRECIATION   OF  PUBLIC  UTILITIES 

years  on  another  and  an  indefinite  life  on  another, 
depending  on  the  amount  of  traffic  carried.  In  this 
case,  like  that  of  the  ties,  a  careful  study  of  renewals 
over  a  period  of  many  years  is  likely  to  furnish  a 
fair  basis  for  computation  on  the  particular  prop- 
erty under  investigation,  provided  records  have 
been  kept  and  provided  an  intelligent  study  and 
analysis  is  made  of  those  records. 

Another  class  of  property  may  have  its  life  de- 
pendent on  extent  and  character  of  use  and  extent 
and  character  of  maintenance,  neither  decay  nor 
wear  and  tear  being  the  important  factor.  Build- 
ings may  be  taken  as  an  example.  Maintenance  may 
be  such  as  practically  to  eliminate  decay,  the  wear 
and  tear  may  or  may  not  have  a  great  effect,  but 
obsolescence  may  affect  one  unit  and  not  another. 
Three  railroad  stations,  built  in  the  same  year,  of 
the  same  design,  in  cities  of  about  8,000  population 
need  not  have  identical  life. 

One  is  destroyed  by  fire  within  a  year,  one  is  built 
in  a  city  which  shows  200  per  cent  increase  of  popu- 
lation in  a  decade  and  becomes  inadequate  in  eight 
or  ten  years,  the  third  is  in  a  city  which  shows  prac- 
tically no  growth  in  forty  years  and  at  the  end  of 
that  time  completely  meets  the  requirements  for 
which  it  was  built. 

In  the  case  of  such  buildings  as  office  buildings 
or  hotels,  the  change  of  a  city  district  from  retail 
to  wholesale,  the  shifting  of  business  to  a  different 
locality  or  other  like  cause,  may  have  a  disastrous 
effect  on  value  by  creating  obsolescence  in  the  build- 
ing even  though  its  physical  condition  be  excellent. 


UNCERTAINTY  OF  DEPRECIATION      99 

There  are  no  dependable  life  tables  covering  such 
things  as  rail,  iron  pipe,  buildings,  boilers,  machin- 
ery, and  the  hundreds  of  kinds  of  items  which  will 
be  found  on  a  large  property.  Practically  all  of  the 
so-called  life  tables  of  this  kind  are  made  up  by 
some  group  of  engineers  and  represent  the  experi- 
ence or  judgment  of  the  members  of  the  group. 
They  are  not  based  on  the  average  experience  with 
hundreds  of  items.  The  figures  in  the  tables  may 
represent  actual  experience  in  only  a  few  cases. 
They  may  represent  the  judgment  of  an  engineer 
based  on  his  own  practice,  observation  or  memory. 
Some  such  tables  are  entitled  to  consideration  as 
being  conscientiously  made,  but  at  the  best  they  are 
wholly  improper  for  general  use. 

It  is  not  contended  that  elapsed  life,  or  probable 
total  life  under  the  conditions  which  exist  on  the 
property  under  investigation  should  not  be  consid- 
ered when  the  engineer  or  accountant  is  engaged 
in  an  estimate  of  depreciation.  As  aids  to  judg- 
ment, properly  used,  and  based  on  a  study  of  op- 
erating statistics  and  actual  experience  on  that  par- 
ticular property  they  may  be  of  value. 

No  general  use  of  life  tables,  especially  by  inex- 
perienced men,  should  ever  be  permitted.  General 
life  tables  are  unreliable  because : 

(a)  They  are  not  life  tables.  They  are  estimates 
based  on  a  very  limited  number  of  cases. 

(h)  The  character  and  extent  of  the  use  of  a 
property  affects  its  life. 

(c)  The  quality  and  extent  of  maintenance  greatly 
affects  the  life  of  property  units. 


100    DEPRECIATION   OF   PUBLIC    UTILITIES 

(d)  The  element  of  obsolescence  cannot  be  tabu- 
lated. In  general  it  may  be  said  that  property  in 
the  small  and  slowly  growing  city  may  be  affected 
little  or  not  at  all  by  obsolescence  while  similar 
property  in  a  large  city  especially  one  that  is  grow- 
ing rapidly  and  making  constantly  larger  demands 
for  the  product  will  have  to  contend  with  large  losses 
through  obsolescence.  It  must  be  remembered  that 
obsolescence  constitutes  one  of  the  principal  reasons 
for  making  replacements,  but  that  the  cost  of  such 
replacements  should  be  a  burden  on  future  rate 
payers  who  derive  the  benefit  from  the  more  eco- 
nomical unit  and  not  on  present  rate  payers. 

Too  much  stress  cannot  be  laid  upon  the  necessity 
for  thorough  study  of  the  operating  statistics  of 
the  property  under  investigation.  An  accounting 
estimate  for  the  purpose  of  setting  up  an  allowance 
to  be  charged  to  operating  expenses  each  year  to 
offset  diminution  in  value  from  all  causes,  is  frankly 
an  estimate.  It  does  not  and  cannot  in  the  nature 
of  things  be  anything  more  than  opinion,  based  on 
evidence  of  more  or  less  value.  This  opinion  should 
take  into  account  the  statistics  of  operation  of  the 
property  in  past  years,  the  judgment  of  operating 
ofificials  and  employees  as  to  the  parts  of  the  prop- 
erty under  their  control,  consideration  of  elapsed 
life,  conditions  under  which  parts  of  the  property 
are  operating,  and  everything  else  that  wall  lead  to 
a  reasonably  correct  figure.  General  life  tables  are 
likely  to  give  results  that  are  far  from  the  truth. 
There  is  no  reason  why,  on  each  property,  a  study 
of  past  renewals  of  certain  classes  of  units  may  not 


UNCERTAINTY  OF  DEPRECIATION    101 

disclose  facts  which  will  establish  reasonably  defi- 
nite life  periods,  for  certain  parts  of  the  property. 
The  use  of  such  information  as  a  basis  of  account- 
ants' estimates  is  thoroughly  proper. 

It  is  to  be  regretted  that  more  actual  information 
as  to  actual  life  and  wear  of  different  kinds  of  prop- 
erty under  different  conditions  has  not  been  made 
available.  As  it  is,  so-called  life  tables  are  often 
productive  of  harm  rather  than  good  and  their  use 
in  computing  a  figure  to  be  deducted  from  value  or 
investment  is  little  short  of  a  crime. 

It  is  a  beautiful  theory  to  assume  that  as  parts 
of  a  property  are  built  and  new  units  replace  old 
ones,  the  useful  life  of  each  unit  will  be  determined, 
its  scrap  value  and  cost  set  up  in  the  books,  and 
some  method  adopted  for  setting  aside  a  reserve 
which  will  at  the  end  of  its  life  accumulate  sufficient 
money  to  retire  that  particular  thing. 

In  the  case  of  locomotives,  passenger  equipment, 
and  other  property  of  such  distinctive  character  that 
individual  records  may  be  kept,  or  in  the  case  of 
large  single  units,  such  as  the  waterworks  equip- 
ment, reservoir  or  filtration  plant,  the  bridge  of 
great  cost,  or  the  railway  terminal,  it  may  be  en- 
tirely practicable  to  so  handle  the  accounting  as  to 
create  reserves  to  cover  the  individual  unit,  or  to 
use  that  computation  as  one  of  the  factors  in  de- 
termining the  proper  allowance  for  the  entire 
property. 

The  abandonment  of  an  electric  power  house  or 
other  operating  unit  of  a  large  property  will  un- 
doubtedly cause  the  retirement  of  hundreds  of  items 


102    DEPRECIATION  OF  PUBLIC  UTILITIES 

which  are  far  from  ready  for  replacement,  many 
indeed  may  be  entirely  new. 

The  theory  fails  in  the  case  of  such  property  as 
a  railroad  track  structure,  a  telephone  or  telegraph 
line,  a  street  railway,  an  electric  light  and  power 
or  a  gas  property,  or  other  large  operating  plants 
composed  of  thousands  of  different  kinds  of  units, 
of  different  cost  and  different  expectations  of  life. 

Once,  in  a  discussion  of  this  subject,  one  well- 
known  engineer  told  the  writer  that  he  would  keep 
individual  accounts  with  every  item,  even  consid- 
ering the  single  railroad  tie  as  an  item.  Such  multi- 
plication of  detail  would  be  costly  and  confusing 
and  would  defeat  the  very  thing  that  was  sought  for. 

Illustrations  might  be  multiplied  indefinitely 
which  prove  the  extremely  uncertain  character  of 
estimates  for  depreciation. 

A  study  of  the  history  of  maintenance,  renewals, 
life  of  items  in  various  groups  or  parts  of  the  prop- 
erty or  on  the  property  as  a  whole  will,  in  the  case 
of  most  operating  concerns,  disclose  some  reason- 
ably definite  basis  for  computation  of  reserves  where 
it  is  necessary  to  use  them.  This  may  be  life  in 
years  based  on  a  study  of  the  property.  It  may  be 
an  allowance  per  car  mile,  per  kilowatt  hour,  per 
million  gallons  of  water  or  per  thousand  feet  of  gas. 
It  may  be  a  percentage  of  gross  earnings,  or  a  per- 
centage of  total  investment  in  certain  groups  of 
property,  or  it  may  be  that  some  other  method  will 
give  the  best  result. 

The  fact  may  just  as  well  be  faced  that  the  de- 
tailed estimate  of  probable  life,  scrap  value,  and 


UNCERTAINTY  OF  DEPRECIATION    103 

depreciable  value,  computed  item  by  item,  is  not 
used  and  not  capable  of  being  used  on  any  large 
percentage  of  the  great  properties  in  the  United 
States.  No  matter  how  good  the  arguments  may  be 
for  the  straight  line  method,  the  compound  inter- 
est method  or  the  unit  cost  method;  no  matter  how 
persuasive  the  diagrams  and  curves  showing  that 
value  diminishes  largely  in  the  first  year;  or  in 
uniform  amounts  each  year;  or  runs  like  Niagara 
with  a  slight  fall  each  year  until  it  nears  its  end 
and  plunges  over  the  cataract  to  zero  value  in  a  few 
months ;  it  must  be  remembered  that  the  great  ma- 
jority of  accountants  do  not  arrive  at  the  annual 
accruals  for  reserves  in  any  such  way.  They  use 
their  best  judgment  as  to  the  amount  to  set  up  each 
year,  in  the  effort  to  set  up  enough  money  fully  to 
meet  the  requirements  and  provide  for  all  necessary 
replacements  as  they  fall  due. 

The  problem  is  to  keep  the  property  intact.  No 
one  can  deny  the  fact  that  progress  toward  replace- 
ment is  always  going  on  and  that  to  charge  simply 
current  repairs  to  operating  expenses  is  not  enough 
in  the  case  of  the  great  waterworks  pump  or  other 
machine  or  structure  of  long  life  and  great  cost, 
where  there  are  but  a  few  such  units. 

No  one  can  deny  that  the  wearing  out  of  property, 
over  and  beyond  current  repairs  is  an  extremely 
difficult  thing  to  compute  with  any  degree  of  accu- 
racy, but  it  must  be  computed  in  the  best  way  pos- 
sible if  ''property  is  to  be  kept  intact  and  investment 
is  to  be  kept  as  it  was  in  the  beginning,"  on  such 
properties  as  cannot  be  kept  to  maximum  operating 


104    DEPRECIATION  OF  PUBLIC  UTILITIES 

efficiency  through  charges  of  replacements  to  oper- 
ating expenses. 

The  Knoxville  case  warns  the  corporation  to  get 
this  money,  and  to  get  enough,  or  "the  fault  will 
be  its  own." 

The  Kansas  City  Southern  case  permits  the  com- 
pany either  to  create  reserves  or  to  charge  direct 
to  operating  expense. 

The  Lincoln  Gas  case  warns  not  to  get  too  much, 
not  to  collect  twice,  once  by  direct  charges  to  oper- 
ating expenses  and  again  by  creating  a  reserve. 

If  the  property  is  earning  large  returns  it  is  to 
the  interest  of  the  owners  to  make  the  amount  set 
aside  for  replacement  or  depreciation  as  great  as 
possible  and  to  the  interest  of  the  consumer  to  make 
it  as  small  as  possible,  therefore  the  subject  con- 
stitutes a  major  issue  in  every  case.  It  may  well 
be  that  such  abuses  as  have  occurred,  such  as  the 
establishment  of  excessive  reserves,  are  the  direct 
and  logical  result  of  the  war  on  values  which  has 
been  waged  by  many  public  officials  and  the  attempts 
of  experts  in  ''Depreciation"  to  deny  a  fair  return 
through  excessive  deductions  from  investment  in 
property. 

In  actual  practice  one  company  sets  aside  20 
per  cent  of  its  gross  earnings  for  maintenance  and 
depreciation,  another  uses  2i/2  to  3  per  cent  per 
year  on  the  total  depreciable  property,  another  uses 
ten  cents  per  car  mile,  another  seven  cents  per  thou- 
sand feet  of  gas  sold,  while  a  fifth  uses  most  elabo- 
rate depreciation  accounting  based  on  life  and  age 
of  units ;  which  one  is  correct? 


UNCERTAINTY  OF  DEPRECIATION     105 

It  may  be  that  in  the  light  of  experience  on  each 
particular  property  each  one  has  made  a  reasonably 
correct  estimate,  yet  none  of  these  methods  can  be 
accepted  as  proper  for  indiscriminate  general  use. 

The  more  free  from  infinite  detail  the  accounting 
is  kept  the  better  it  is  likely  to  be,  for  depreciation 
accounting  is  not  a  recording  of  absolute  facts,  but 
of  guess,  estimate,  or  judgment,  as  we  may  please 
to  call  it,  as  to  the  proper  amount  of  money  that 
will  be  needed  to  do  certain  things  that  may  have 
to  be  done  much  sooner  or  much  later  than  the  time 
which  we  in  our  best  judgment  fixed  as  the  probable 
date  of  replacement. 


\^ 


CHAPTER  XI 

DEPRECIATION— LOSS  OF  VALUE  WHICH 
SHOULD  BE  DEDUCTED 

Theke  is  perhaps  no  subject  connected  with  the 
entire  field  of  utility  valuation  and  regulation  which 
is  more  difficult  to  handle,  or  regarding  which  a 
wider  range  of  opinions  has  been  expressed  by 
courts,  commissions  and  engineers  than  this  ques- 
tion of  the  determination  of  the  proper  figure  to 
deduct  when  making  an  appraisal  for  use  as  a  basis 
of  ratemaking. 

There  can  be  no  argument  at  all  about  the  fact 
that  everything  built  by  man  does  actually  depre- 
ciate. It  either  wears  out  or  decays,  or  it  may  lose 
all  its  money  value  through  becoming  obsolete  or 
inadequate. 

One  difficulty  comes  in  determining  just  exactly 
what  construction  is  to  be  placed  on  the  statements 
of  the  United  States  Supreme  Court  in  certain  of 
its  decisions,  in  squaring  different  statements  in 
the  same  decision  with  one  another,  and  in  reconcil- 
ing various  decisions,  and,  after  these  things  have 
been  done,  in  arriving  at  some  rational  plan  for  com- 
puting the  amount  of  deductable  loss. 

106 


DEPRECIATION— LOSS  OF  VALUE      107 

One  other  hard  thing  to  do  is  to  keep  clear  the 
difference  between  property  which  is  privately 
owned  in  relatively  small  single  units,  and  property 
in  the  form  of  one  great  composite  instrument  of 
service  made  up  of  hundreds  of  thousands  of  units 
of  many  different  kinds,  one  property,  operating 
under  a  franchise  and  under  obligation  to  do  certain 
things. 

The  writer  is  fully  convinced  that  a  great  deal 
of  the  work  of  valuation  that  has  been  done  in  the 
past  has  been  done  without  proper  conception  of 
the  property  as  being  one  whole,  of  continuing  life, 
and  much  of  it  has  been  done  on  a  very  erroneous 
conception  of  the  meaning  really  intended  by  the 
courts  in  some  of  their  decisions.  Then  too,  much 
of  it  has  been  undertaken  in  a  partisan  spirit,  and 
arguments  have  been  adduced  and  figures  presented 
which  have  not  only  not  clarified  the  issues,  but 
have  confused  them,  and  have  possibly  caused  the 
courts  to  use  terms  which  failed  to  convey  exact 
shades  of  meaning  intended. 

The  attempt  is  here  made  to  show  that  the  de- 
cisions of  the  courts  are  not  inconsistent. 

The  Supreme  Court  squarely  holds  to  the  con- 
cepts : 

{a)  That  the  duty  rests  upon  the  company  to 
maintain  its  property,  through  ordinary  repairs 
and  maintenance  and  through  renewals  of  parts  of 
the  property,  so  that  its  value  shall  not  depreciate 
and  so  that  the  investment  in  the  property  ''shall 
be  maintained  as  it  was  in  the  beginning."  (Knox- 
ville  case,  212  U.  S.  1.) 


108    DEPRECIATION  OF  PUBLIC  UTILITIES 

{h)  Apparently  in  direct  conflict  with  the  above 
are  the  statements  that  the  estimate  of  cost  of  re- 
production would  give  incorrect  results  if  ''not 
diminished  by  the  depreciation  which  has  come  from 
age  and  use."    (Knoxville  case,  212  U.  S.  1.) 

The  Knoxville  case  has  already  been  discussed 
and  it  has  been  shown  that  the  company  admitted 
two  kinds  of  depreciation  but  claimed  that  not  only 
existing  depreciation  in  the  property  in  use,  but 
also  the  depreciation  of  long  ago  in  the  form  of 
property  that  had  ceased  to  exist,  should  be  added 
to  the  present  value  of  useful  property. 

The  decision,  it  seems  to  the  writer,  is  capable  of 
only  one  interpretation  and  that  is  that  actual  de- 
preciation which  amounts  to  loss  of  value  of  the  in- 
vestment shall  he  deducted.  Justice  Moody  sums  up 
this  concept  in  the  last  paragraph  of  the  decision 
as  follows: 

"If  however  a  company  fails  to  perform  this  plain  duty  and  to 
exact  suflBcient  returns  to  keep  the  investment  unimpaired, 
whether  this  is  the  result  of  unwarranted  dividends  upon  over 
issues  of  securities,  or  of  omission  to  exact  a  proper  price  for  the 
output,  the  fault  is  its  own." 

No  subsequent  decision  of  the  court  changes  this 
interpretation  in  the  least.  The  Minnesota  rate 
cases  state,  "The  Master  allowed  the  cost  of  re- 
production new  without  deduction  for  depreciation. 
It  was  not  denied  that  there  was  depreciation  in 
fact."  In  this  respect  the  presentation  of  the  case 
is  similar  to  that  of  the  Knoxville  case.  The  decision 
further  says: 


DEPRECIATION— LOSS  OF  VALUE      109 

"It  is  also  to  be  noted  that  the  depreciation  in  question  is  not 
that  which  has  been  overcome  by  repairs  and  replacements,  but 
is  the  actual  existing  depreciation  in  the  plant  as  compared  with 
the  new  one.  It  would  seem  to  be  inevitable  that  in  many  parts  of 
the  plant  there  should  be  such  depreciation,  as  for  example  in 
old  structures  and  equipment  remaining  on  hand.  And  when  an 
estimate  of  value  is  made  on  the  basis  of  reproduction  new,  the 
extent  of  existing  depreciation  should  be  shown  and  deducted/' 
(Minnesota  Rate  cases,  230  U.  S.  352.)     (Italics  ours.) 

It  is  well  known  to  every  manager  of  property 
and  to  every  engineer  who  has  been  engaged  upon 
the  work  of  valuation  that  on  all  large  properties 
of  every  kind  the  inventory  which  is  made  of  all 
property  owned  by  the  company  will  include  build- 
ings or  machines  still  in  existence,  which  have  ceased 
to  perform  the  function  they  were  originally  built 
for,  and  have  been  replaced  by  new  property  but 
which  are  stiU  in  place,  sometimes  connected  up 
and  capable  of  service,  sometimes  used  in  a  new 
form  of  service  of  less  importance,  and  sometimes 
merely  awaiting  a  purchaser.  The  writer  could 
cite  dozens,  perhaps  hundreds,  of  illustrations  of 
such  cases,  in  nearly  all  of  which  the  unit  either 
called  for  classification  as  unused  property,  or  for 
a  low  valuation  on  the  ground  that  the  new  service 
did  not  justify  any  such  investment.  Practically 
every  property  has  a  number  of  such  cases.  The 
writer  does  not  see  in  this  case  any  support  of 
theoretical  depreciation,  so  called,  or  estimated 
elapsed  life,  as  a  proper  figure  to  be  deducted  in 
finding  a  rate  base. 

The  Kansas  City  Southern  case  was  an  account- 
ing case  dealing  with  property  which  was  aban- 


no    DEPRECIATION   OF  PUBLIC  UTILITIES 

doned.  The  court  says,  "The  real  question  is  not 
how  original  cost  shall  be  ascertained  but  how  shall 
subsequent  depreciation  in  value  be  reckoned  and 
accounted  for."  The  case  was  one  of  complete  de- 
preciation, property  ceasing  to  exist: 

"Except  for  the  contention  (already  disposed  of)  that  the  value 
of  the  abandoned  parcels  should  be  permanently  carried  in  the 
property  account  as  part  of  the  cost  of  progress,  it  is  and  must 
be  conceded  that  sooner  or  later  it  must  be  charged  against  the 
operating  revenue,  either  past  or  future,  if  the  integrity  of  the 
property  accounts  is  to  be  maintained;  and  it  becomes  a  question 
of  policy  whether  it  should  be  charged  in  solido  to  profit  and  loss 
(an  account  presumptively  representative  of  past  accumulations) 
or  to  the  operating  accounts  of  the  present  and  future.  If 
abandoned  j^roperty  is  not  charged  off  in  one  way  or  the  other 
it  remains  as  a  permanent  inflation  of  the  property  accounts,  and 
tends  to  produce,  directly  or  indirectly,  a  declaration  of  dividends 
out  of  capital."  {Kansas  City  Southern  vs  United  States,  231 
U.  S.  423.) 

The  Supreme  Court  consistently  holds  that  the 
property  accounts  shall  truly  reflect  the  facts.  If 
property  is  added,  the  capital  account  is  to  be  in- 
creased ;  if  property  disappears,  the  capital  account 
shall  be  diminished.  The  duty  of  the  company  is 
always  to  maintain  investment,  but  if  they  fail  to 
charge  enough  in  rates  to  permit  them  to  do  so,  or 
charging  enough  pay  it  out  improperly,  and  do  not 
maintain  the  property,  the  depreciation  which 
amounts  to  loss  of  value  is  to  be  deducted  in  the 
determination  of  capital  entitled  to  a  return.  The 
test  must  be  this,  has  the  property  actually  been 
maintained  to  the  maximum  standard?  The  writer 
fails  to  see  anything  in  any  of  these  decisions  that 


DEPRECIATION— LOSS  OF  VALUE      111 

can  be  construed  into  a  demand  that  anything  more 
shall  be  deducted  than  actual  loss  of  value.  Pre- 
sumably such  loss  of  value  is  meant  as  can  be  put 
back  into  the  property,  or  such  loss  as  is  due  to 
property  units  ceasing  to  be  a  part  of  the  operating 
property  engaged  in  rendering  the  service.  The 
obligation  to  keep  ''as  it  was  in  the  beginning" 
effectually  closes  the  door  on  any  such  theory  as 
the  one  that  would  deduct  an  amount  from  existing 
used  and  useful  property  which  never  can  be  put 
back. 

In  practically  every  valuation  that  has  been  made 
during  the  past  twenty  years  the  engineers  doing 
the  work  have  made  an  estimate  of  depreciation. 
Absolute  candor  compels  the  admission  that  a  large 
amount  of  this  work  has  been  pure  guess  work  based 
either  upon  so-called  inspection  or  upon  arbitrary 
use  of  life  tables.  Much  of  this  estimating  has  been 
done  without  regard  to  accounting  methods  used  by 
the  company  or  without  knowledge  as  to  whether 
or  not  the  company  had  in  the  past  kept  depreciation 
accounts  or  had  charged  replacements  to  operating 
expenses. 

It  is  true  that  there  have  been  a  number  of  really 
fine  studies  of  the  subject  of  depreciation  estimat- 
ing, and  much  of  this  part  of  the  valuation  work  that 
has  been  done  has  had  real  merit,  but  on  the  whole 
the  work  done  in  recent  years  has  not  shown  the 
progress  which  might  have  been  expected.  As  the 
writer  has  come  into  contact  with  this  class  of  work, 
he  feels  that  a  number  of  criticisms  are  generally 
applicable  to  it. 


L^ 


112    DEPRECIATION   OF  PUBLIC  UTILITIES 

(a)  There  has  been  a  complete  failure  to  consider 
the  entire  property  as  one  operating  property,  one 
composite  whole,  built  and  maintained  for  service. 
Rather  the  attempt  has  been  to  appraise  it  as  a  col- 
lection of  individual  items,  each  considered  alone 
without  reference  to  the  number  of  such  items,  the 
method  of  their  maintenance  or  renewal,  or  the  ac- 
counting system  used. 

(fc)  There  has  been  a  general  acceptance  of  the 
life  conception  of  accrued  depreciation.  That  is, 
if  the  assumption  is  made  that  a  thing  has  a  total 
life  of  ten  years,  and  it  has  lasted  five  years,  it  is 
therefore  in  50  per  cent  condition  and  the  50  per  cent 
has  been  deducted. 

(c)  There  has  been  an  almost  complete  failure 
to  consider  the  amount  of  money  that  it  would  be 
economically  wise  and  proper  to  expend  on  a  prop- 
erty at  the  time  of  investigation  to  restore  the 
property  as  a  whole  to  the  maximum  condition  that 
might  be  hoped  for,  or  to  such  condition  as  it  would 
be  reasonable  or  justifiable  to  put  it  into  in  order 
to  fully  meet  all  demands  upon  it. 

{d)  There  has  been  a  constant  use  of  the  hypo- 
thetical "new  property"  as  a  standard  of  compari- 
son, and  not  of  the  maximum  operating  condition, 
or  normal  property  which  is  obtained  by  investment. 
The  ''new  property,"  absolutely  new  in  all  its  parts, 
is  a  myth,  unattainable  in  any  case  of  a  large  organ- 
ization, and  a  thing  that  is  of  no  value  could  it  be 
obtained  because  it  could  not  be  kept  new.  No  one 
ever  sought  a  new  property.  The  maximum  which 
can  be  secured  and  kept  is  the  operating  property 


DEPRECIATION— LOSS  OF  VALUE      113 

with  parts  of  it  in  all  stages  of  life,  whose  average 
condition  of  expired  life  may  be  75,  80,  85  per  cent 
or  some  other  percentage  condition  which  can  be 
maintained  practically  constant  by  current  repairs 
and  replacements  made  when  economically  due.  The 
first  and  last  of  these  criticisms  have  been  quite 
fully  considered  in  earlier  chapters.  The  second  and 
third  will  be  discussed  more  fully,  with  illustrations, 
to  bring  out  if  possible  the  facts  which  ought  to  be 
disclosed. 

Much  of  the  valuation  work  of  the  past  has  been 
based  on  the  theory  that  every  one  of  the  many 
individual  items  of  which  a  railroad  or  other  prop- 
erty is  made  up  has  an  average  expectation  of  life 
which  can  be  estimated,  and  a  definite  age  which  can 
be  determined,  and  that  this  age,  or  elapsed  portion 
of  the  total  life  constitutes  the  depreciation  or 
''accrued  depreciation."  This  theory  is  plausible 
and  has  won  many  advocates.  Here  is  an  automo- 
bile. It  is  four  years  old.  The  average  life  of  a 
large  number  of  similar  machines  whose  history 
is  of  record  was  actually  five  years.  Therefore  this 
automobile  is  certainly  worth  but  a  small  fraction 
of  its  original  value. 

The  automobile,  one  complete  unit  of  transporta- 
tion, of  short  life,  and  the  only  one,  or  one  of  only 
two  or  three  belonging  to  its  owner,  is  not  com- 
parable to  a  railroad  of  several  hundred  miles  nor 
is  it  comparable  to  any  one  of  the  individual  items 
owned  by  the  railroad,  or  to  one  of  the  automobiles 
owned  by  an  electric  power  company.  The  single 
privately  owned  automobile  is  capital  investment 


114    DEPRECIATION   OF   PUBLIC   UTILITIES 

in  transportation  property  and  its  wearing  out  is 
depletion  of  capital,  the  utility  owned  automobile 
is  consumable  supplies,  tlie  wearing  out  of  it  is  a 
legitimate  part  of  the  operating  expenses  of  the 
company. 

One  of  the  best  illustrations  of  this  that  can  be 
considered  is  railroad  track,  made  up  of  rails,  ties, 
track  fastenings,  special  work  and  labor. 

Long  before  anyone  thought  of  valuation  or  de- 
preciation, the  railroads  in  establishing  their  sys- 
tems of  accounting  made  certain  obvious  groupings 
of  material  or  labor  into  separate  accounts  such  as 
rails,  ties,  ballast,  track  and  roadway  labor,  grading 
and  other  accounts.  This  was  purely  a  matter  of 
convenience.  Engineers  in  estimating  new  work 
used  the  same  groupings,  and  it  followed  as  a  per- 
fectly natural  consequence  that  when  valuation  work 
was  first  done  the  same  groupings  were  adopted. 
This  was  proper  as  a  matter  of  convenience,  ease 
and  accuracy  in  accounting,  estimating  or  valuation, 
but  it  does  not  justify  the  assumption  that  these 
accounts  represent  units  of  property.  The  indi- 
vidual tie  or  the  single  rail  or  the  single  spike  is 
no  more  a  proper  unit  than  the  single  shingle  or 
the  single  pane  of  glass  in  a  residence.  The  tie 
decays  to  such  a  point  that  it  ceases  to  serve,  the 
rail  breaks  and  a  replacement  becomes  at  once 
economically  necessary.  The  great  railroad  run- 
ning its  many  trains  over  the  track  is  neither  de- 
creased in  value  by  the  condition  of  the  tie  previous 
to  the  time  of  its  removal  nor  is  it  increased 
in  value  by  the  replacement.    The  smallest  unit  of 


DEPRECIATION— LOSS  OF  VALUE      115 

use  that  can  possibly  be  considered  is  the  track. 
The  entire  roadbed  and  track  with  all  of  the  aux- 
iliary track  structures  is  more  nearly  a  unit  because 
of  the  impossibility  of  separating  the  maintenance 
costs  incurred  in  keeping  up  the  cuts  and  embank- 
ments, the  ballast,  the  track,  the  fences  and  other 
parts  of  the  roadway  structure.  This  maintenance 
is  all  done  by  the  same  forces,  and  the  nature  of  the 
work  is  such  that  it  is  impossible  to  determine  the 
exact  cost  of  maintaining  the  ties,  or  the  rail,  or  any 
of  the  other  parts  of  the  roadway  structure,  the 
materials  of  which  are  assigned  to  separate  ac- 
counts. 

The  track  must  be  kept  in  normal  condition  for 
operation,  in  the  best  possible  condition  that  can 
be  maintained,  hence  the  ties  and  the  rails  are 
replaced  at  the  first  moment  when  their  condition 
warrants  the  change  and  the  expense  becomes  justi- 
fiable. The  whole  operation  is  comparable  to  burn- 
ing of  coal  in  the  locomotive.  A  tender  is  filled  with 
coal,  it  is  gradually  used  up  until  a  point  is  reached 
where  the  tender  must  be  refilled.  The  burning  of 
coal  is  no  more  essential  to  the  operation  of  the 
railroad  than  the  consuming  of  the  tie. 

In  just  the  same  way  the  residence  must  be  main- 
tained by  the  replacement  of  the  shingle  when  it 
causes  a  leak  or  the  pane  of  glass  when  it  breaks. 
If  the  residence  is  maintained,  kept  painted,  and  all 
renewals  made  when  due,  the  question  of  value  is 
not  arrived  at  by  fixing  the  hypothetical  life  of  the 
shingles,  glass,  nails  and  other  material  entering 
its  construction.    The  residence  as  a  whole  property 


116    DEPRECIATION   OF   PUBLIC    UTILITIES 

and  the  railroad  track  as  a  whole  property  are  the 
fundamental  units. 

Actually  valuation  engineers  have  concerned 
themselves  with  the  ties  and  the  rail  and  have  in 
most  cases  made  deductions  from  value  based  on 
comparing  with  the  hypothetical  new  tie  or  rail. 

The  writer  had  before  him  one  of  the  valuations 
of  the  Interstate  Commerce  Commission  of  one  of 
the  small  railroads  of  the  country. 

Account  7,  Ties,  shows  a  reproduction  of  $748,190 
and  a  reproduction  less  depreciation  or  fair  value 
of  $374,095;  in  other  words,  a  deduction  of  50  per 
cent  for  depreciation  of  ties.  Applying  the  same 
rate  of  depreciation  per  mile  as  is  applied  to  this 
little  road  to  all  of  the  railroad  mileage  in  the 
United  States  the  resultant  figure  shows  a  deduc- 
tion of  at  least  $350,000,000  from  the  value  of  the 
railroad  properties  on  the  item  of  ties  alone,  a  figure 
of  sufficient  magnitude  to  compel  a  most  careful 
study. 

This  particular  railroad  is  over  forty  years  old. 
In  the  last  twenty-five  years  its  main  line  mileage 
has  not  changed  over  a  quarter  of  a  mile.  The 
writer  was  its  Chief  Engineer  during  the  years 
1890-1896,  and  has  been  familiar  with  it  ever  since. 
The  ties  are  certainly  in  no  worse  condition  today 
than  thirty-two  years  ago.  In  fact,  they  are  better 
because  the  ton-miles  per  mile  of  road  in  1915  (the 
year  of  the  valuation)  were  935,000  as  against 
410,000  in  1892.  The  writer  knows  of  his  own  per- 
sonal knowledge  that  the  quality  of  maintenance  is 
better  now  than  it  was  in  the  early  nineties.     The 


DEPRECIATION- 


LOSS  OF  VALUE      117 
When  did 


query  is:  what  is  this  ''depreciation' 
it  accrue? 

The  computation  is  about  as  follows:  A  railroad 
system  has  ties  to  the  average  number  of  approxi- 
mately 2,800  per  mile.  The  life  is  found  to  be  or  is 
assumed  to  be,  let  us  say,  ten  years.  There  would 
be  on  an  average  mile,  in  the  autumn  after  all  re- 
newals are  made  for  the  year: 


280  ties  with  an  expectancy  of  life  of  10  years    2,800  tie  years 

280 

9     ' 

'       2,520 

280 

8     ' 

'       2,240 

280 

7     ' 

1,960 

280 

6     ' 

1,680 

280 

5     ' 

'       1,400 

280 

4     ' 

'       1,220 

280 

3     ' 

840 

280 

2     ' 

560 

280 

1     ' 

280 

2,800 


15,400 


The  condition,  after  making  the  year's  renewals 
would  therefore  represent  55  per  cent  of  the  total 
tie-years  of  life  in  the  hypothetical  *  *  new  property, ' ' 
which  would  of  course  have  2,800  ties  with  full  ten- 
year  life  or  28,000.  In  the  spring  before  any  re- 
newals are  made  the  minimum  condition  would  be 
12,600  tie-years  remaining  or  an  average  condition 
of  45  per  cent.  It  is  therefore  assumed  that  an  all- 
year  average  condition  of  50  per  cent  will  about 
state  the  fact.  This  is  then  called  depreciation  and 
in  hundreds  of  cases  this  amount  has  been  deducted 
from  the  total  value  assigned  to  the  ties. 

The  American  Society  of  Civil  Engineers'  Com- 


118    DEPRECIATION   OF   PUBLIC   UTILITIES 

mittee  has  used  the  term  Decretion,  loss  of  service 
life,  as  a  more  appropriate  term  to  apply  to  this 
condition  of  age  or  progress  toward  the  necessity  for 
replacement.  This  is  exactly  descriptive  of  what  it 
is.  There  is  undoubtedly  such  an  element  of  de- 
cretion in  all  property  that  has  been  in  use.  The 
writer  makes  no  attempt  to  argue  it  away.  Some 
good  engineers  have  been  puzzled  by  it.  They  have 
recognized  its  inevitable  presence,  they  know  that 
it  is  absolutely  impossible  to  possess  a  property  of 
any  kind  that  has  not  a  large  element  of  decretion 
that  can  be  computed,  and  they  know  that  it  is  not 
loss  of  value. 

If  we  refer  to  the  illustration  given,  an  average 
mile  of  ties,  and  if  we  assume  that  all  renewals  in 
the  past  have  been  made  when  due  so  that  the  table 
represents  a  true  condition  at  the  end  of  the  year, 
it  is  evident  that  the  total  decretion  during  the  year 
is  2,800  ties,  each  losing  one  year  of  life,  or  2,800 
tie-years  of  decretion.  Replacements  are  made  of 
280  ties  each  with  ten  years'  expectation,  or  2,800 
tie-years,  hence  the  replacements  exactly  equal  the 
decretion  and  there  is  consequently  no  depreciation 
during  the  year. 

It  must  not  be  forgotten  that  this  assumption  is 
based  upon  complete  maintenance  to  economic 
maximum  condition.  When  that  is  not  done  there 
is  clearly  depreciation,  loss  of  value,  to  just  the  ex- 
tent of  the  failure  to  maintain. 

If,  to  continue  the  illustration,  the  mile  in  ques- 
tion for  four  years  past  had  only  60  per  cent  of  the 
proper  number  of  new  ties,  and  only  186  ties  per 


DEPRECIATION— LOSS  OF  VALUE      119 

year  had  been  put  in  instead  of  280,  there  would  be 
a  depreciation  of  4,480  tie-years  or  16  per  cent.  This 
is  really  depreciation,  measurable  in  the  dollars  that 
would  have  to  be  expended  to  restore  the  property 
to  its  normal  condition  and  to  replace  every  tie  that 
the  company  would  be  economically  justified  in  re- 
placing. 

In  other  words,  as  the  writer  views  the  problem, 
decretion  while  admittedly  existing,  calls  for  the 
expenditure  of  no  money,  indeed  no  one  could  find 
any  economic  justification  for  the  expenditure  of 
money  to  replace  non-obsolete  property  merely  be- 
cause of  decretion.  Depreciation  is  a  dropping 
below  the  standard  of  maximum  condition,  it  means 
either  failure  to  make  needed  current  repairs  or  it 
means  past  due  replacements  and  when  the  investi- 
gation of  the  property  is  made  it  must  be  taken 
into  account. 

One  will  naturally  ask  when  this  decretion  occurs 
and  why  it  should  not  be  construed  as  the  kind  of 
''depreciation  from  age  and  use"  w^hich  was  re- 
ferred to  by  the  court.  It  has  been  shown  that  where 
tie  renewals  are  made  as  needed  the  renewals  offset 
the  decretion.  In  every  property  there  is  a  period, 
after  its  first  construction,  during  which  renewals 
are  very  light,  gradually  increasing,  and  finally 
reaching  a  period  when  on  the  entire  property  they 
become  reasonably  uniform  in  amount  each  year  in 
such  a  case  as  ties. 

A  railroad  is  not  at  any  time  ever  *'new"  in  the 
same  sense  that  an  automobile  is  purchased  new 
from  a  dealer.     The  whole  operation  of  getting  a 


120    DEPRECIATION  OF  PUBLIC  UTILITIES 

new  automobile  takes  an  hour,  the  getting  of  a  new 
railroad  three  hundred  miles  long  takes  three,  four 
or  possibly  more  years.  The  railroad  which  was 
referred  to  at  the  beginning  of  this  discussion  was 
actually  commenced  in  1877  and  finished  to  its  pres- 
ent terminus  in  1889  some  construction  work  being 
done  every  year  during  ten  years  of  this  period. 
From  the  beginning  of  the  track-laying  to  the  final 
completion  of  the  finished  road  and  putting  it  into 
operation,  a  period  of  many  months  must  elapse 
during  which  ties,  rail  and  other  parts  of  the  struc- 
ture get  hard  wear  under  bad  conditions.  All  this 
time  decretion  is  accruing  and  in  the  case  of  a  long 
line  of  road  it  might  well  be  that  the  full  amount 
of  decretion  in  ties  has  accrued  during  construction. 

Certainly  no  one  w^ould  contend  that  deductable 
depreciation  would  begin  before  a  property  was  fin- 
ished, before  it  was  even  new  in  the  sense  that  it 
was  ready  to  begin  giving  service,  yet  that  is  exactly 
what  happens  in  the  case  of  the  ties. 

The  answer  would  appear  to  be  that  the  decretion 
in  a  public  utility  property,  or  that  loss  of  service 
life  of  the  various  units  which  has  disappeared, 
but  ivhicJi  never  can  be  restored  to  the  property  by 
any  amount  of  maintenance  or  renewal  which  is  jus- 
tified by  any  consideration  of  economics  or  common 
sense,  occurs  during  the  early  years  of  the  life  of 
the  property.  It  is  in  a  way  a  part  of  the  process 
of  development  of  a  property,  the  change  from  a 
new  instrument  to  an  instrument  of  maximum  serv- 
ice value.  It  would  seem  to  the  writer  to  be  a  wiser 
course  to  attempt,  from  an  inspection  of  the  physical 


DEPRECIATION— LOSS  OF  VALUE       121 

plant  and  accounts  of  each  property,  to  fix  a  standard 
of  normal  condition,  or  economic  maximum  condi- 
tion, and  use  that  as  a  basis  for  the  estimate  of  de- 
preciation below  that  condition,  rather  than  to  com- 
pute total  decretion  and  then  attempt  to  offset  all 
or  part  of  it  by  estimating  a  wholly  theoretical 
*  Agoing  concern"  or  "cost  of  development"  element 
of  intangible  value  and  adding  that. 

Is  it  not  much  more  rational  to  stick  to  the  propo- 
sition that  capital  accounts  should  represent  the 
bona  fide  investment  in  property  plus  accretions, 
and  that  this  investment  secured  a  plant  in  maxi- 
mum service  condition  or  what  may  be  termed 
normal  service  condition?  Then  any  dropping 
below  such  maximum  condition  is  depreciation  to  be 
deducted.  The  measure  of  that  depreciation  is  the 
amount  of  money  that  should  be  spent  on  the  prop- 
erty to  bring  it  back  to  normal  service  condition. 
This  form  of  computation  is  perfectly  rational  and 
does  not  go  nearly  so  far  into  the  realms  of  guess- 
ing, hypothesis  or  conjecture  as  is  required  by  the 
other  method  which  has  been  described  and  which 
has  been  most  generally  used. 

The  writer  does  not  believe  that  decretion  should 
be  considered  as  depreciation,  or  deducted  from 
value,  in  rate  cases,  unless  it  appears  from  an  ex- 
amination of  the  accounts  that  special  accounting 
has  been  done  and  estimated  annual  allow^ances 
have  been  set  up  and  reserves  accumulated  to  cover 
the  decretion.  Where  this  has  been  done  and  where 
money  has  been  put  into  funds  which  are  being 
used  by  the  company,  the  investigation  must  go  to 


122    DEPRECIATION   OF   PUBLIC   UTILITIES 

the  use  of  money.  Clearly  the  company  may  not 
collect  from  the  rate  payers  for  replacement  and 
decretion  and  at  the  same  time  use  the  money  so 
collected  for  other  purposes  and  still  claim  a  return 
on  the  full  investment. 

The  obligation  to  take  notice  of  the  method  of 
accounting  used  in  the  past  and  allow  for  it  is  just 
as  heavy  on  the  regulating  body  as  the  obligation 
to  deduct  depreciation  when  it  exists,  and  clearly 
requires  the  regulating  body  not  to  deduct  that 
which  does  not  in  actual  fact  exist  as  loss  of 
value : 

"If,  in  the  past,  reconstinietion  and  replacement  charges  have 
been  met  out  of  current  expenses,  the  fact  must  be  taken  into 
consideration,  both  when  we  come  to  estimating  future  net  income 
and  in  determining  what  sum  shall  annually  be  set  aside  to  guard 
against  future  depreciation."  (Lincoln  Gas  and  Electric  Com~ 
pany  vs  City  of  Lincoln,  223  U.  S.,  p.  349,  1912.) 

It  may  be  contended  that  the  foregoing  argument 
is  based  wholly  on  the  illustration  of  the  ties  and 
that  it  is  not  applicable  to  other  items,  even  of  the 
track. 

As  has  been  stated,  it  is  necessary  for  purposes 
of  estimating  to  use  such  divisions  of  property  or 
material  units  as  may  be  traced  to  the  accounting 
records  of  the  company.  What  has  been  said  of  ties 
is  equally  true  of  rail,  but  be  it  remembered  that 
rail  is  replaced  several  miles  at  a  time,  so  that  in- 
stead of  the  average  mile  as  a  basis  for  rail  replace- 
ment studies,  it  would  be  necessary  to  take  the  entire 
line,  say  from  Detroit  to  Chicago.    Inasmuch  as  the 


DEPRECIATION— LOSS  OF  VALUE      123 

rail  wears  out,  and  as  the  real  basis  for  decretion 
is  the  rather  indeterminable  one  of  work  units,  it 
is  necessary  on  each  road  to  establish  actual  experi- 
ence, when  it  will  be  found  that  the  same  principle 
applies  and  that  decretion  on  a  large  system  will  be 
found  to  stand  at  some  fairly  definite  percentage. 

While  considering  railroad  track  it  must  be  borne 
in  mind  that  many  thousands  of  miles  of  track  exist 
which  have  not  only  not  depreciated  but  which  have 
actually  grown  better  year  after  year  although  all 
the  time  carrying  just  as  much  decretion  (and  no 
more)  as  at  the  present  time.  Indeed  any  new  track, 
just  completed,  is  far  from  being  as  valuable  or  as 
safe  as  the  same  track  will  be  after  the  expiration 
of  ten  or  fifteen  years  of  proper  maintenance. 

The  views  herein  expressed  are  directly  in  line 
with  a  number  of  recent  decisions  of  courts. 

In  New  York  and  Queens  Gas  Company  vs  New- 
ton, 269  Fed.  277,  Special  Master  Gilbert  discusses 
depreciation  at  considerable  length : 

"No  Reduction  for  'Accrued  Theoretical  Depreciation.'  In 
determining  that  the  complainant's  property  has  a  fair  present 
ralue  of  at  least  the  amount  of  the  complainant's  actual  invest- 
ment therein  as  found  by  me,  viz.  at  least  $1,655,877.94.  I  have 
made  no  deduction  for  what  is  termed  'depreciation,'  in  whatever 
■way  calculated.  Under  any  basis  of  determining  present  value, 
the  complainant's  property  is  now  worth  at  least  the  amount  of 
Buch  investment  therein,  and  the  sound  rule  of  law  and  policy 
Beems  to  require  the  allowance  of  a  reasonable  return  upon  at 
least  that  sum." 

"Present  Condition  of  the  Property.  Mr.  Miller  testified  that, 
as  of  April,  1920,  the  expenditure  of  $6,144.07  for  repairs, 
renewals,  and  replacements,  would  put  the  plant,  structures,  ma- 


124    DEPRECIATION   OF   PUBLIC   UTILITIES 

chinery,  and  equipment  in  condition  substantially  as  good  as 
when  they  were  erected  or  installed.  His  testimony  in  this 
respect  was  not  contradicted  by  that  of  any  witness.  This  sum, 
however,  does  not,  in  my  opinion,  measure  any  impairment  in  the 
present  value  of  the  property  used  and  useful  in  the  gas  business. 
It  represents  merely  an  unmatured  obligation  to  maintain  the 
property  in  efficient  operating  condition  out  of  future  earnings; 
the  expert  witnesses  of  both  the  complainant  and  the  defendants 
agreeing  that  it  was  and  is  maintained  in  efficient  and  first-class 
condition.  I  therefore  have  not  deducted  this  or  any  other  sum 
representing  so-called  'accrued  depreciation'  from  the  amount 
found  by  me  to  represent  the  investment  of  the  complainant  in 
its  gas  property  upon  which  it  is  entitled  to  have  its  rate  such 
as  to  yield  a  reasonable  return." 

This  finding  was  approved  by  Judge  Mayer  of  the 
United  States  District  Court  on  Dec.  13,  1920,  and 
by  the  Supreme  Court  on  March  6,  1922. 

Just  one  week  previous  to  this  the  United  States 
Court  of  Appeals,  for  the  Sixth  Circuit,  in  a  decision 
of  Judge  Knappen  ruled  on  depreciation  in  a  taxa- 
tion case,  Nashville,  Chattanooga  and  Saint  Louis 
Railway  Company  vs  United  States,  269  Fed.  351, 
Dec.  7, 1920 : 

"The  testimony,  considered  as  a  whole,  tended  to  support  the 
conclusion  that  the  amounts  expended  by  defendant  during  the 
years  in  question  for  repairs,  renewals,  and  replacements  should 
and  would  have  fully  offset  the  depreciation  in  the  various  units, 
and  that  the  defendant's  railway  and  structures  were,  as  a  whole, 
maintained  throughout  the  years  in  question  in  fully  as  good 
condition,  and  were  of  fully  as  great  intrinsic  value,  as  at  the 
beginning  of  the  respective  years.  The  jury  would  have  been 
clearly  justified  in  inferring  from  the  testimony  of  defendant's 
chief  engineer,  taken  as  a  whole,  that  the  value  of  the  roadway 
had  not  depreciated  during  the  two  years  in  question;  in  other 


DEPRECIATION— LOSS   OF  VALUE       125 

words,  that  the  repairs  and  renewals  that  had  been  made  were  of 
such  a  character  as  to  leave  the  road  at  the  end  of  each  year 
of  value  equal  to  that  at  the  beginning  of  the  year.  That  officer's 
testimony  so  impressed  the  trial  judge,  who  stated  his  opinion 
from  the  evidence  that  'there  is  no  reasonable  deduction  for 
depreciation  established.'  Defendant  did  not  directly  controvert 
the  situation  so  shown.  Its  chief,  if  not  its  only,  reliance  seems 
to  have  been  on  the  proposition  that,  in  spite  of  it  all,  there  was 
inevitable  annual  depreciation  in  some  of  the  perishable  elements 
not  entirely  renewed  or  replaced,  so  justifying  the  contention  that 
for  this  reason  there  was  depreciation  within  the  meaning  of  the 
act,  even  though  the  roadway  as  a  whole  had  not  decreased  in 
value.  To  this  argument,  as  already  said,  we  cannot  assent.  It 
follows  that  the  trial  judge  rightfully  refused  to  instruct  verdict 
for  defendant. 

"Finding  no  error  in  the  record,  the  judgment  of  the  District 
Court  is  affirmed." 

It  is  impossible  to  get  away  from  the  consideration 
of  the  two  general  groups  into  which  all  utility 
properties  must  be  divided  for  purposes  of  depreci- 
ation accounting.  Eatio  of  operating  expenses  to 
gross  earnings  must  be  kept  uniform  or  reasonably 
so  year  after  year  if  the  company  is  to  avoid  years 
of  apparently  excessive  profits  or  years  of  appar- 
ently light  profits  or  losses,  a  condition  which 
would  greatly  tend  to  impair  credit  and  value  of 
securities. 

The  track,  consisting  largely  of  ties,  rail  and  labor, 
can  be  classed  as  property  which  may  be  kept  in  uni- 
form condition  by  charging  replacements  to  operat- 
ing expenses.  The  many  thousands  of  single  items, 
the  possibility  of  replacing  parts  continuously  from 
day  to  day  without  disturbing  service,  make  this  an 
ideal  illustration  of  the  one  class. 


126    DEPRECIATION   OF  PUBLIC   UTILITIES 

Large  machines  like  waterworks  pumps,  electric 
turbo  generators  or  other  very  costly  single  units, 
great  railway  terminal  properties,  dams  and  hy- 
draulic properties,  and  other  large  things  which 
cannot  go  out  of  service  without  seriously  affecting 
the  operating  expenses  if  charged  in  one  year  are 
most  notable  examples  of  the  other  class. 

Midway  between  these  extremes  are  many  kinds 
of  property  which  in  the  case  of  one  company  can 
be  handled  by  direct  charges  to  operating  expenses, 
while  in  the  case  of  other  companies  might  be  better 
handled  through  the  creation  of  reserves. 

In  every  case,  however,  decretion  exists.  It  may 
be  that  deductable  depreciation  or  loss  of  value  also 
should  be  found,  but  this  is  not  decretion  or  ''theo- 
retical depreciation"  and  should  not  be  confused 
with  it.  The  fact  can  only  be  disclosed  by  a  care- 
ful accounting  investigation  as  well  as  by  a  thorough 
physical  inspection  and  the  test  of  depreciation  or 
loss  of  value  is  as  to  whether  or  not  it  is  econom- 
ically justifiable  to  make  an  expenditure  of  money 
in  maintenance  that  has  been  neglected  or  replace- 
ment that  is  overdue. 

If  the  company  has  collected  from  the  rate  payers 
through  charges  to  operating  expenses  for  some 
building  or  machine  or  piece  of  equipment  which 
takes  over  the  functions  of  some  other  building  or 
machine  and  the  latter  goes  out  of  service,  but  re- 
mains in  position  or  is  converted  to  some  inferior 
service,  there  is  clearly  a  case  of  the  kind  of  depre- 
ciation referred  to  in  the  Knoxville  and  Minnesota 
rate  cases.    There  are  probably  few  if  any  proper- 


DEPRECIATION— LOSS  OF  VALUE      127 

ties  which  do  not  have  a  number  of  instances  of  the 
kind  referred  to  by  Justice  Hughes  when  he  spoke 
of  ''old  structures  and  equipment  remaining  on 
hand."  There  are  probably  few  properties  in  which 
there  will  not  be  found  a  considerable  amount  of 
depreciation  which  should  be  deducted  in  finding 
*'fair  value." 

The  writer  is  by  no  means  an  advocate  of  the 
theory  that  investment  in  public  utility  property 
once  made  should  not  be  reduced  by  the  deduction 
of  depreciation  which  amounts  to  loss  of  value.  No 
such  contention  can  possibly  be  sustained.  It  is, 
however,  contended  that  elapsed  life,  decretion,  or 
progress  toward  replacement,  let  it  be  called  by 
whatsoever  name  one  will,  is  not  depreciation  in  the 
sense  that  the  Supreme  Court  used  that  word  when 
saying  that  a  deduction  should  be  made.  If  there 
exists  in  the  property  any  part  which  ought  to  have 
been  replaced  or  is  now  ready  for  replacement,  and 
the  replacement  can  be  justified,  there  certainly  is 
depreciation  or  loss  of  value  which  can  be  measured 
by  the  amount  of  money  which  should  presently  be 
spent  to  put  the  property  as  a  whole  in  proper  con- 
dition. 

In  a  great  modern  office  building  there  will  be 
found  hundreds  of  cubic  feet  of  brick  walls  or  tile 
walls,  thousands  of  square  feet  of  glass  or  of  plas- 
tering. If  the  building  is  ten  years  old  there  is 
decretion  or  elapsed  life  in  every  item.  In  making 
a  valuation  of  the  building  one  uses  these  units  for 
the  purpose  of  computation,  but  one  does  not  sit 
down  with  four  or  five  associates  and  place  an  ar- 


128    DEPRECIATION   OF   PUBLIC   UTILITIES 

bitrary  life  of  twenty  years  on  glass  and  then  deduct 
50  per  cent  of  tlie  total  reproduction  cost  of  the 
glass. 

As  far  as  physical  property  depreciation  is  con- 
cerned, one  makes  a  careful  examination  of  the 
property  and  estimates  the  total  replacement  of 
glass  and  total  labor  to  bring  it  back  to  maximum 
condition  and  replace  all  broken  panes. 

The  depreciation  of  the  building  is  not  based  on 
the  physical  property  condition  alone.  Obsoles- 
cence, the  changing  character  of  business  in  the 
neighborhood  and  other  similar  factors  cannot  be 
ignored  and  these  things  account  for  loss  of  value 
to  a  far  greater  extent  than  any  mere  failure  to 
maintain.  Some  of  these  elements  might  perhaps 
be  deductable,  others  it  would  seem  should  not  be 
because  they  are  a  burden  on  future  consumers,  not 
on  past  or  present  consumers. 

The  writer  is  of  the  opinion  that  the  proper 
method  of  fixing  the  amount  of  physical  property 
depreciation  is  to  make  a  study  of  the  property 
under  investigation,  determine  its  proper  normal 
condition  taking  into  account  the  extent  and  charac- 
ter of  the  business,  the  demands  upon  the  property, 
the  extent  and  quality  of  past  maintenance  over 
a  period  of  years,  and  to  estimate  carefully  the  work 
that  ought  to  be  done  to  bring  the  entire  property, 
as  one  operating  entity,  up  to  the  normal  operating 
condition,  or  the  maximum  condition  in  which  it 
should  be  maintained  having  due  regard  for  all 
economic  considerations. 

No  expenditure  that  is  not  justified  by  sound  busi- 


DEPRECIATION— LOSS   OF  VALUE      129 

ness  judgment  should  be  included.  The  obligation 
upon  the  company  to  maintain  its  property  always 
is  in  existence.  The  obligation  is  on  the  public  not 
to  demand  an  expenditure  that  is  not  economically 
justified.  Replacement  and  maintenance  costs  must 
be  borne  by  the  consumer,  hence  the  consumers  con- 
stitute that  part  of  the  public  most  vitally  interested. 

Property  which  has  ceased  to  function,  but  which 
still  exists,  will  generally  have  been  superseded  by 
other  property,  and  in  all  such  cases  the  question 
as  to  whether  or  not  it  should  be  included  in  the 
valuation  or  should  have  deduction  made  on  ac- 
count of  loss  of  value  by  reason  of  the  new  use  or 
of  non-use  can  be  readily  determined. 

Robert  A.  Carter  and  William  L.  Ransom  sum- 
marize and  paraphrase  their  conclusions  drawn 
from  a  study  of  recent  court  and  commission  de- 
cisions as  follows: 

"If  a  utility's  i:)atrons  have  received  its  service  at  a  fair  price 
based  upon  actual  cost  including  a  fair  return  on  its  investment, 
and  not  at  a  price  inflated  by  the  arbitrary  inclusion  therein  of 
a  provision  for  theoretical  depreciation,  no  deduction  for  depre- 
ciation should  be  made  from  the  value  of  its  property.  If  on  the 
other  hand,  it  has  been  so  misgnided  as  to  accrue  'reserves'  on  the 
'theoretical  depreciation'  basis  and  has  exacted  from  its  patrons 
an  additional  charge  therefor,  the  amount  thus  exacted  is  com- 
monly deducted  from  the  value  of  its  property." 

The  American  Society  of  Civil  Engineers'  Com- 
mittee reaches  conclusions  as  follows: 

"(o)  Replacement  Method. — If  by  order  or  sanction  of  a  regu- 
lating body,  or  by  long  continued  proper  custom  under  no  regula- 
tion, a  property  has  been  maintained  in  normal  working  condi- 


130    DEPRECIATION  OF  PUBLIC  UTILITIES 

tion,  necessarily  less  than  new  in  some  or  all  of  its  parts,  by  the 
replacement  method,  and  at  any  given  date  is  being  valued  for 
any  public  purpose  and  at  that  date  shows  normal  condition,  all 
its  several  parts  being  in  as  good  condition  as  could  be  expected, 
the  accounts  showing  that  always  those  amounts  have  been  ex- 
pended in  renewals  that  were  necessary  to  keep  the  property  in 
normal  working  condition,  and  the  fact  appearing  that  no  ex- 
penditure reasonably  to  be  expected  could  put  the  property  in 
better  than  the  normal  condition  in  which  it  is  found,  and  that 
no  unusually  large  expenditure  is  presently  to  be  necessary  for 
this  purpose,  then,  in  spite  of  the  fact  that  there  is  an  existing 
decretion  in  its  several  parts,  there  should  be  found  no  deprecia- 
tion of  valuation.  Under  the  method  of  accounting,  the  public 
has  not  paid,  and  could  not  pay,  for  the  accrued  depreciation, 
and  under  this  condition  its  accrued  obligation  to  pay  should  be 

considered  an  asset  of  the  company  owner." 

•  *  «  *  • 

"(b)  Allowance  Methods. — If  either  the  straight-line  or  sink- 
ing-fund theory  has  been  used  in  computing  depreciation  and 
the  method  of  accounting  for  it  has  been  prescribed  by  a  regu- 
lating body  or  voluntarily  followed  by  a  company  owner  from 
the  beginning,  the  same  theory,  so  far  as  it  applies  to  the  prop- 
erty in  question,  should  be  used  for  estimating  the  cost  of  decre- 
tion, and  the  entire  cost  so  found  lessened  by  any  accumulated 
depreciation  funds  will  appear  as  depreciation  of  valuation, 
unless  the  sinking-fund  method  of  accounting  has  been  used.  In 
the  latter  case,  if  the  valuation  has  to  do  with  the  reasonableness 
of  the  return  and  the  accounting  is  to  go  on  as  before,  apparently 
existing  depreciation  would  not  be  depreciation  of  valuation, 
and  therefore  would  not  be  deductable ;  but  if  the  valuation  has  to 
do  with  condemnation  or  purchase,  then,  as  in  other  cases,  the 
apparently  existing  depreciation  is  depreciation  of  valuation,  and 
the  owner  sliould  receive  the  depreciated  value  of  the  physical 
property  and  the  existing  fund."  * 

The  writer  believes  that  these  opinions  are  sound 
as  to  non-obsolescent  property. 

♦  See  Trans.  Am.  Sac.  C.  E.,  rol.  81,  pp.  1493-1494. 


CHAPTER  XII 
OBSOLESCENCE 

Obsolescence  has  been  defined  by  the  American 
Society  of  Civil  Engineers'  Conunittee  on  Valuation 
as  ' '  The  condition  or  process  by  which  units  gradu- 
ally cease  to  be  useful  or  profitable  as  part  of  the 
property  on  account  of  changed  conditions."  This 
definition  is  broad  enough  to  include  all  forms  of 
outgrown,  inadequate  or  obsolete  property. 

A  generator  in  an  electric  power  station,  installed 
within  five  years,  may  be  rendering  just  as  good 
service  as  on  the  day  of  its  first  operation,  and  may 
be  generating  current  at  no  higher  cost  than  when 
first  installed.  But  new  inventions  have  been  made 
and  more  modern  types  of  generators  are  on  the 
market  which  are  capable  of  producing  current  at 
considerably  less  cost.  Here  is  an  illustration  of 
obsolescence,  although  the  unit  may  be  in  perfect 
condition  and  doing  all  that  it  was  guaranteed  to 
do.  It  may  be  that  the  business  being  served  is  of 
such  a  character  as  not  to  justify  the  replacement 
of  the  machine. 

A  railway  passenger  terminal  originally  built  to 
serve  a  city  of  75,000  people  is  too  cramped  and 
small  to  give  modern  or  proper  service  to  the  city 

131 


132    DEPRECIATION   OF   PUBLIC   UTILITIES 

now  increased  to  250,000  population.  While  still 
in  use  and  in  excellent  physical  condition,  it  is  com- 
pletely inadequate  and  its  replacement  is  only  a 
matter  of  time  and  the  ability  of  the  railroad 
to  j&nance  the  new  project. 

A  hotel  in  a  large  city  built  a  few  years  ago  has 
lost  its  high  class  patronage  for  the  reason  that  a 
change  in  the  kind  of  business  or  character  of 
population  in  its  immediate  vicinity  has  left  it  in 
a  section  of  the  city  that  is  distinctly  undesirable, 
remote  from  the  office  and  shopping  districts  which 
formerly  were  in  its  neighborhood. 

These,  and  many  other  examples  which  might  be 
cited,  indicate  that  obsolescence  in  some  of  its 
many  forms  has  a  real  bearing  on  the  question  of 
value.  In  the  case  of  such  property  as  the  hotel, 
or  the  large  office  building,  there  always  exists  the 
possibility  that  the  shifting  of  business  may  wipe 
out  a  large  part  of  the  value  of  the  improvement 
to  land. 

There  has  been  no  uniformity  of  practice  among 
valuation  engineers  in  the  matter  of  treatment  of 
obsolescence.  One  will  disregard  it  entirely,  another 
will  consider  it  and  possibly  modify  his  figures 
slightly  on  account  of  the  obviously  obsolete  charac- 
ter of  certain  units  of  property,  while  a  third  will 
make  heavy  deductions  in  arriving  at  fair  value. 

It  is  time  that  this  question  was  squarely  met  and 
some  uniformity  of  treatment  agreed  upon. 

Manifestly,  if  the  investor  in  an  enterprise  is  to 
have  a  return  on  his  investment  and  to  have  his 
money  back  when  he  goes  out  of  business,  he  must. 


OBSOLESCENCE  133 

especially  if  lie  is  going  into  such  an  investment  as 
the  hotel  or  the  office  building,  have  keen  regard  for 
this  matter  of  obsolescence  and  must  plan  to  amor- 
tize his  investment  in  considerably  less  time  than 
he  would  if  no  such  thing  existed. 

Whether  the  utility  corporation  should  do  the 
same  thing  is  the  question  at  issue.  There  is  a  fun- 
damental difference  between  the  owner  of  the  hotel 
and  the  owner  of  the  generator. 

It  appears  to  the  writer  that  there  should  be  a 
sharply  drawn  line  between  the  treatment  of  obso- 
lescence in  the  case  of  the  public  utility  property 
which  was  built  to  render  a  continuing  service  of 
indefinite  life,  and  that  of  the  non-utility  property, 
such  as  the  hotel  or  the  office  building,  where  service 
terminates  when  the  plant  reaches  the  end  of  its 
life,  and  where  there  is  no  obligation  to  continue  the 
service. 

In  the  latter  case  it  is  clearly  good  business  policy 
to  attempt  to  anticipate  and  provide  for  the  pos- 
sible early  retirement  of  the  property. 

The  problem,  as  far  as  it  affects  public  utility 
properties  has  two  aspects:  What  is  the  proper 
accounting  treatment?  How  shall  obsolescence  be 
treated  when  arriving  at  "fair  value"  for  rate  mak- 
ing? 

The  two  parties  at  interest,  the  investor  and  the 
rate  payer  will  naturally  tend  to  take  opposite  views 
on  these  questions.  The  report  of  President  Theo- 
dore N.  Vail  to  the  stockholders  of  the  American 
Telephone  and  Telegraph  Company  (quoted  on 
pages  78  to  85)  takete  the  stand  that  obsolescence 


134    DEPRECIATION   OF   PUBLIC   UTILITIES 

and  inadequacy,  supersession  by  reason  of  new  in- 
ventions and  discoveries,  and  changes  in  popular 
demand  or  public  requirements  are  among  the  main 
reasons  for  creating  large  reserves. 

The  memorandum  filed  with  the  Interstate  Com- 
merce Commission  by  Robert  A.  Carter  and  William 
L.  Ransom  already  referred  to,  discusses  this  sub- 
ject from  the  rate  payers'  viewpoint  as  follows: 

"The  wearing'  parts  of  units  of  railway  property  are  currently 
repaired  as  needed,  and  the  effect  is  to  maintain  the  unit  in 
existence  and  in  high  operating  efficiency,  for  an  indefinite  and 
undefinable  period,  and  the  expense  of  this  repair  and  replace- 
ment of  wearing  parts  is  properly  assessed  by  the  company 
executives  against  the  current  cost  of  rendering  the  service  in 
which  the  use  and  wear  took  place. 

"The  responsible  executives  of  the  carrier  also  realize  that 
although  the  newly  installed  unit  may  continue  in  use  for  an  in- 
definite and  incalculable  period,  if  thus  maintained  in  good  oper- 
ating condition,  it  may  go  out  of  use,  for  other  causes  than  wear 
or  the  flight  of  time,  and  that  such  retirement  from  use  may  come 
about  at  almost  any  time — a  time  in  no  way  susceptible  of  esti- 
mate at  the  time  it  is  installed,  but  varying  altogether  with  the 
particular  carrier,  the  particular  territory  being  served,  the 
nature  of  the  service  being  rendered,  the  various  factors  affecting 
the  cost  of  service,  and  the  like.  The  unit  may  be  retired  from 
use  because  it  has  become  inadequate  to  meet  the  growing  de- 
mands for  service  (and  hence  is  uneconomical)  or  because  new 
inventions  have  resulted  in  improvements  in  the  type  of  a  given 
unit,  making  its  retirement  economical  in  the  interests  of  future 
patrons.  A  larger  volume  of  traffic  can  be  handled  or  the  existing 
volume  of  traffic  can  be  handled  more  cheaply  or  more  efficiently, 
if  the  present  unit  is  removed  and  a  new  one  put  in,  although  the 
unit  taken  out  is  still  functioning  as  efficiently  as  when  installed. 
The  time  when  such  supersession  of  a  unit  will  take  place  cannot 
be  forecast  in  terms  of  years,  by  company  executives,  engineers, 
or  anyone  else,  at  the  time  the  unit  is  installed.    'Tables  of  useful 


OBSOLESCENCE  135 

lives'  of  units  of  that  kind  are  unavoidably  conjectural  and 
speculative,  bearing  no  possible  relationship  to  the  controlling 
factors,  which  vary  utterly  with  the  individual  instance.  To  try 
to  'assign'  a  probable  period  of  'life'  to  the  unit  when  it  is 
installed,  and  then  charge  against  current  rates  an  accrual  based 
on  the  amortization  of  the  cost  of  the  unit  over  that  period,  la  to 
set  up  a  system  of  swelling  operating  expenses  and  'padding' 
rates  on  a  basis  of  mere  conjectures,  because  with  the  great  mass 
of  railway  property  its  proper  maintenance  by  current  repairs 
consigns  all  'life  tables'  to  the  realm  of  silly  impracticabilities, 
and  supersession,  when  it  does  take  place,  occurs  for  causes  in  no 
way  related  to  such  'life  tables.'  Moreover,  such  supersession 
comes  about  for  causes  which  make  improper  the  amortization  of 
its  cost  through  increased  rates  during  the  period  before  it  is 
superseded.  The  unit  did  not  wear  out  in  the  service  of  the 
patrons  it  served.  They  paid  the  cost  of  maintaining  it  in  good, 
undiminished  operating  efficiency;  there  is  no  reason  why  they 
should,  in  addition,  pay  the  cost  of  retiring  it  to  put  in  a  new 
unit  which  will  serve  more  patrons  or  serve  future  patrons  more 
cheaply.  The  existing  unit  was  serving  present  patrons  effi- 
ciently; the  cost  of  retiring  it  to  put  in  a  larger  or  more 
economical  unit  becomes  a  proper  charge  against  those  who  will 
be  served  and  benefited  thereby.  The  expense  of  retiring  prop- 
erty should  therefore  be  borne  by  current  or  future  charges,  and 
not  by  anticipatory  accruals  {Kansas  City  Southern  Railway 
Company  vs  United  States,  231  U.  S.,  423,  451-2) ;  in  other 
words,  the  retiring  of  a  very  large  unit  may  necessitate  the  dis- 
tribution of  the  amortization  of  the  investment  therein,  over  a 
short  period  of  succeeding  years. 

"It  thus  appears  that  wherever  departure  is  made  from  the 
actual  current  outlays,  year  by  year,  for  repairs  and  for  the 
renewal  and  replacement  of  property  withdrawn  from  service, 
'depreciation'  charges  in  operating  expenses  should  in  any  event 
be  restricted  to  those  necessary  to  equalize  from  year  to  year  the 
charges  for  extraordinary  repairs  and  for  renewals  and  replace- 
ments which  occur  irregularly.  As  experience  shows  that  in 
large  plants  and  other  utilities  whose  property  is  distributed  suf- 
ficiently widely  to  be  subjected  to  a  variety  of  hazard,  the  actual 


136    DEPRECIATION  OF  PUBLIC  UTILITIES 

costs  of  repairs  and  retirements  tend  to  equalize  themselves  when 
taken  over  a  period  of  years,  it  is  apparent  that  there  is  no  need 
at  all  for  })ermitting  the  introduction  of  estimated  charges  in 
operating  expenses  to  cover  the  matter  of  'depreciation'  in  con- 
nection with  the  determination  of  a  fair  level  of  rates  as  defined 
in  the  statute,  unless  the  Commission  contemplates  frequent  re- 
adjustments of  the  rate  level.  If  such  frequent  readjustments  are 
contemplated,  the  regulation  of  such  charges  should  be  based  on 
the  actual  present  and  past  experience  of  the  carriers,  and  the 
charges  themselves  should  be  proportioned  on  the  basis  of  the 
work  done  rather  than  on  mere  lapse  of  time." 

There  is  no  known  rule  for  estimating  obsoles- 
cence. In  one  case  with  which  the  writer  was  con- 
nected one  engineer  testified  that  certain  street  rail- 
way track  in  a  city,  built  at  a  cost  of  over  $60,000 
per  mile,  an  entirely  new  line  constructed  with  new 
material  on  streets  never  previously  occupied,  less 
than  a  year  old,  should  have  a  deduction  of  15  to 
20  per  cent  on  account  of  obsolescence  because  the 
standard  plans  under  which  it  was  built  were  fifteen 
years  old  and  the  general  advance  in  knowledge  of 
the  art  was  such  as  to  justify  the  charge  that  the 
type  was  obsolete.  There  are  thousands  of  cases 
of  plant  which  is  obsolete  but  still  rendering  excel- 
lent service  under  conditions  which  do  not  warrant 
its  supersession.  It  is  probably  correct  to  say  that 
there  is  little  service  property  of  any  kind  in 
America  that  is  not  to  some  degree  affected  by  ob- 
solescence. 

Any  attempt  to  fix  a  figure,  in  dollars,  to  be 
deducted  in  case  of  valuation,  as  loss  of  value  on 
account  of  obsolescence,  is  conjectural  and  hypo- 
thetical in  the  extreme.    It  must  be  remembered  that 


OBSOLESCENCE  137 

there  are  hundreds  of  little  utility  companies  in 
hundreds  of  little  communities,  which  are  giving  a 
service  that  is  desired  and  essential  to  the  welfare 
of  the  community,  which  are  operating  on  so  small 
a  margin  of  profit  that  they  cannot  keep  abreast  of 
the  latest  developments.  The  consumers  can  not 
hope  for  either  the  quality  or  cheapness  of  service 
that  can  be  given  by  the  great  corporation  in  the 
great  city.  Public  policy  will  not  permit  the  estab- 
lishment of  accounting  rules  which  will  permit  the 
owners  of  such  properties  to  set  up  reserves  to  care 
for  possible  future  obsolescence  and  thus  place  a 
burden  on  consumers  who  derive  no  benefits.  Public 
policy  should  not  permit  the  owners  of  the  property 
to  be  penalized  for  conditions  which  they  cannot 
control  when  the  fixing  of  value  for  rates  is  the 
issue. 

It  seems  clear  that  when  the  great  utility  property 
finds  it  economical  to  displace  an  engine  or  gener- 
ator or  other  piece  of  property  on  account  of  the 
fact  that  operating  economics  can  be  affected,  the 
computation  should  include  the  carrying  of  the  un- 
amortized portion  of  the  superseded  unit.  The  rate 
payers  served  by  the  new  and  more  economical  unit 
should  complete  the  amortization  of  the  unit  which 
was  displaced  in  order  that  they  might  get  the  ad- 
vantage of  the  greater  economy  of  the  new  unit. 

Changes  on  account  of  obsolescence  or  inadequacy 
are  never  made  unless  there  is  a  clear  saving  by 
reason  of  the  change,  or  unless  the  business  has 
grown  more  rapidly  than  was  anticipated,  or  unless 
the  growth  and  development  of  the  community  war- 


138    DEPRECIATION  OF  PUBLIC   UTILITIES 

rants  a  complete  change  of  plant  to  allow  for  this 
development. 

In  either  case  the  burden  ought  not  to  be  placed 
on  the  owner  of  the  property,  nor  yet  on  past  con- 
sumers. The  consumers  of  the  product  of  the  new 
and  more  economical  unit  are  the  ones  who  should 
carry  the  cost  of  progress.  They  should  not  derive 
a  benefit  from  excessive  rates  charged  to  consumers 
in  early  years,  the  excess  charge  being  based  on  the 
assumption  that  the  change  might  take  place. 

It  has  already  been  argued  that  the  rate  payer 
should  not  be  made  to  pay  excessive  charges  to  de- 
preciation. He  should  pay  all  operating  expenses. 
He  should  pay  for  all  renewals  of  property  worn 
out  in  service,  he  should  provide  enough  money  to 
equalize  from  year  to  year  the  charges  for  extra- 
ordinary repairs,  but  he  should  not  be  made,  under 
the  guise  of  "depreciation"  or  ''obsolescence"  to 
pay  rates  which  will  in  addition  to  these  things  build 
up  a  large  surplus  for  the  benefit  of  the  owners  of 
the  property. 

When  it  comes  to  the  question  of  "fair  value,"  it 
would  seem  that  the  treatment  already  proposed 
would  be  adequate. 

No  deduction  from  value  on  purely  conjectural 
grounds  should  be  considered.  If  a  property  has 
obsolete  equipment  or  equipment  that  is  not  wholly 
up  to  date  it  seems  fair  to  assume  either  that  sound 
business  policy  will  dictate  its  replacement  by  a 
more  economical  unit,  in  which  case  the  question  of 
obsolescence  is  one  for  future  operating  expenses, 
or  that  the  economies  to  be  affected  are  not  enough 


OBSOLESCENCE  139 

to  justify  the  supersession.  If  this  latter  be  the 
case  the  presumption  is  that  the  unit  will  continue 
to  serve  until  worn  out  in  service  and  replaced  in 
the  ordinary  course  of  maintenance. 

The  United  States  Supreme  Court  has  discussed 
this  kind  of  depreciation  in  the  Kansas  City  South- 
ern case  (231  U.  S.  423),  in  the  following  language: 

"The  other  kind  of  depreciation  is  the  result  of  changes  at- 
tributable to  the  inadequacy  of  the  existing  property  to  meet  the 
demands  of  the  future.  The  road  or  the  structure  have  to  be 
replaced  with  stronger  or  more  efficient  instrumentalities.  Aban- 
donments occasioned  by  changes  of  this  character  are  therefore 
chargeable  to  future  earnings,  for  the  reason  that  the  improved 
condition  of  the  road  is  not  only  designed  to  meet  the  demands  of 
the  future,  but  presumably  will  result  in  economies  of  operation, 
and  so  the  resulting  benefits  will  be  reaped  by  those  who  hold 
stock  of  the  company  in  the  present  and  in  the  future." 

The  only  other  case  in  which  this  subject  is  fully 
discussed  is  in  New  York  and  Queens  Gas  case  (269 
Fed.  277)  in  which  Special  Master  Gilbert  reports 
as  follows : 

*'The  Renewal  and  Replacement  of  Gas  Property. — In  other 
words,  in  order  to  keep  abreast  of  improvements  in  the  art  of 
making  and  distributing  gas  when  and  as  it  becomes  economically 
advantageous  to  do  so,  and  to  meet  the  growing  demand  of  the 
public  for  service  more  adequately  and  economically  than  would 
be  possible  through  merely  making  additions  and  extensions  to 
existing  plant  and  equipment,  larger  or  better  and  more  econom- 
ical and  efficient  units  of  plant  and  equipment  are  from  time  to 
time  installed,  to  take  the  place  of  units  which  are  still  operating 
as  efficiently  as  when  first  installed.  The  loss  due  to  such  super- 
session cannot  properly  be  said  to  have  accrued  during  the  period 
the  superseded  unit  was  in  service.    It  occurred  when  supersession 


140    DEPRECIATION  OF  PUBLIC  UTILITIES 

took  place.  It  became  a  proper  charge  against  the  economies  to 
be  realized  therefrom.  It  furnished  no  basis  for  the  imposition 
of  an  additional  charge  against  the  user  of  the  superseded  unit 
during  the  period  of  its  useful  service,  over  and  above  the  higher 
cost  of  operating  it.  Such  a  charge  could  not  be  justified,  either 
on  the  ground  that  the  unit  was  losing  potential  life,  or  that  the 
capital  invested  in  it  was  being  consumed,  because  neither  is  true." 


CHAPTER  XIII 
CONCLUSION 

The  attempt  has  been  made  in  the  previous  chap- 
ters to  discuss  depreciation,  and  to  touch  upon  those 
other  matters  which  seemed  essential  to  a  clear 
understanding  of  the  argument.  ''Fair  Value"  has 
been  referred  to  only  to  the  extent  of  setting  up  the 
two  theories  and  making  clear  the  issues  now  being 
presented  to  the  courts  in  many  cases. 

The  unprecedented  growth  of  all  of  our  Ameri- 
can business,  not  only  the  utilities,  but  manufactur- 
ing and  commerce  of  all  classes  since  the  Civil  War, 
and  especially  since  1900  has  given  rise  to  a  series 
of  questions  which  never  bothered  our  fathers.  The 
great  development  of  new  industries,  and  the  thou- 
sands of  new  inventions  have  added  to  the  complica- 
tions. Hence  we  have  had  to  work  out  rules  to 
govern  the  relationships  between  the  utility  com- 
panies and  the  millions  of  people  who  depend  on 
their  output.  This  we  have  called  Regulation  of 
Public  Utilities. 

Forty  years  ago  no  one  gave  thought  to  deprecia- 
tion or  cared  much  about  how  the  accounting  of  the 
corporations  was  done. 

141 


142    DEPRECIATION  OF  PUBLIC  UTILITIES 

Twenty  years  ago  depreciation  was  set  up  in  the 
early  valuations,  not  so  much  for  the  purpose  of 
deducting  it,  as  to  attempt  to  make  a  comparison  of 
the  existing  property  with  the  same  property  in  an 
all  new  condition.  Fifteen  years  ago  we  commenced 
to  regulate  and  prescribe  accounting  methods. 

Then  followed  a  flood  of  discussion  and  deprecia- 
tion was  made  a  mysterious  and  complex  thing  by 
reason  of  the  fact  that  one  group  of  engineers 
wanted  to  deduct  the  accrued  loss  of  service  life, 
another  group  claimed  there  was  no  depreciation  at 
all,  while  the  accountants  talked  about  another  thing 
entirely  and  called  it  "depreciation."  The  use  of 
such  terms  as  depreciation,  accrued  depreciation, 
theoretical  depreciation,  physical  depreciation, 
functional  depreciation,  and  a  number  of  others 
which  were  coined  to  try  and  express  the  idea  which 
was  sought  to  be  conveyed  only  tended  to  complicate 
and  confuse  the  subject. 

What  is  now  needed  is  greater  clarity  of  expres- 
sion and  greater  emphasis  on  the  fundamental 
things. 

The  company  which  accepts  a  franchise  to  fur- 
nish service  is  under  obligation  to  build  a  property, 
to  maintain  that  property  and  to  render  that  service, 
not  for  a  month,  or  a  year,  but  continuously,  and 
in  the  case  of  railroads  and  many  other  utilities 
indefinitely. 

The  property  so  built  is  one  instrument  of  service, 
and  it  is  that  property  as  a  whole  which  must  be 
considered,  and  not  the  materials  and  machines 
and  labor  that  enter  into  it. 


CONCLUSION  143 

The  money  with  which  this  property  must  be 
built  comes  from  our  own  citizens  of  all  classes.  It 
is  clear  that  money  cannot  be  drawn  into  public 
utility  investments  unless  there  is  reasonable  pros- 
pect of  a  fair  return  and  assurance  that  money  so 
invested  is  protected  and  the  permanency  of  the 
investment  secured. 

The  one  property,  designed  for  service  must  be 
maintained  always  in  a  safe  and  adequate  condition 
to  render  the  continuous  service  that  is  required. 
The  maintenance  of  that  property  and  the  replace- 
ment of  its  parts  as  they  need  renewal  are  operat- 
ing expenses  pure  and  simple.  Property  In  maxi- 
mum economic  condition  for  service  is  the  only  thing 
which  can  be  secured  by  investment.  It  must  be 
kept  in  that  condition  by  replacement  of  parts  as 
they  wear  out.    The  obligation  is  to  maintain. 

The  manner  of  accounting  for  replacement  is  a 
matter  of  detail  not  of  principle.  Whether  replace- 
ments are  charged  to  operating  expenses  direct 
when  made,  or  whether  reserves  are  created  based 
on  estimates  of  the  proper  amounts  needed  to  per- 
petually maintain  the  property,  is  a  matter  of  policy 
to  be  determined  by  the  regulating  commission  or 
management.  The  plan  adopted  for  the  accounting 
allowances,  *' straight  line"  or  some  sinking  fund 
method  is  purely  a  question  of  accounting  detail. 

The  important  thing  is  the  maintenance  of  the 
property  and  the  securing  of  the  money  for  main- 
tenance in  such  a  way  that  operating  expenses  will 
be  kept  reasonably  uniform  year  after  year. 

Loss  of  value  or  depreciation  of  valuation  to  be 


144    DEPRECIATION   OF  PUBLIC  UTILITIES 

found  in  determining  of  ''fair  value"  represents  the 
failure  of  the  company  to  maintain  its  property  and 
to  make  renewals  when  they  were  due  and  should 
have  been  made.  An  unmatured  obligation  to  make 
a  renewal  is  not  loss  of  value. 

The  user  of  the  product,  the  rate  payer,  should 
pay  all  costs  of  production  and  of  maintenance  of 
plant,  and,  sufficient  to  give  such  a  return  to  get  all 
needed  capital  for  expansion.  He  should  not  be 
called  upon  for  excessive  charges,  under  the  guise 
of  "depreciation"  or  operating  expenses,  beyond 
the  real  needs  of  the  company. 
^  The  consumer  cannot  be  expected  to  underwrite 

excessive  or  ill-advised  investments  nor  to  guaran- 
tee a  return  on  properties  built  where  there  is  no 
real  demand  for  the  services. 

This  last  statement  seems  to  touch  the  difficult 
point.  The  commissions  in  charge  of  regulation  are 
dealing  with  all  kinds  of  properties— large  and 
small,  strong  and  weak — companies  that  are  oper- 
ated by  business  men  of  the  highest  degree  of 
intelligence  and  companies  that  are  controlled  by 
men  with  no  knowledge  of  the  business  except  what 
they  have  picked  up  on  some  little,  ill-designed  and 
insignificant  plant  with  no  business  and  no  future. 

Human  nature  with  its  selfishness  and  prejudice 
and  bias  still  further  complicates  the  question;  so 
that,  in  the  last  analysis,  each  case  must  be  settled, 
as  to  its  own  details,  by  the  commission  in  charge. 
Many  things  come  in  to  influence  the  decision  that 
do  not  appear  in  the  record  or  in  the  opinion.    It 


CONCLUSION  145 

is  certain  that  new  questions  will  continue  to  come 
up  in  the  future  as  our  national  business  grows,  and 
that  the  work  of  regulation  will  tend  to  increase 
year  after  year.  If  we  can  establish  a  few  more 
definite  principles  and  especially  dispose  of  these 
questions  of  depreciation  and  "fair  value"  we  will 
have  made  real  progress. 

These  public  utility  issues  are  matters  of  vital 
interest  to  the  nation.  The  United  States,  as  a 
nation,  owes  its  oneness,  its  freedom  from  clan  and 
dialect,  to  the  fact  that  just  as  the  population  began 
to  move  back  from  the  Atlantic  seaboard,  the  rail- 
road was  developed,  and  as  the  railroad  mileage 
increased  and  new  lines  reached  into  the  unsettled 
territory  the  population  increased.  In  a  real  way 
the  prosperity,  yes  the  life,  of  this  nation  is  bound 
up  with  the  prosperity  of  the  railroads,  because  this 
nation  more  than  any  other  nation  in  the  world  is 
built  upon  the  foundation  of  railroad  transporta- 
tion. 

In  just  the  same  way  our  cities  depend  upon  the 
other  utilities.  Only  through  the  invention  of  the 
telephone,  the  city  transportation  systems,  electric 
light  and  electric  power  has  the  building  of  great 
cities  been  made  possible  and  without  all  of  them, 
and  with  them  gas  and  water,  we  could  not  live  in 
the  cities. 

The  relationship  between  investor  and  rate  payer, 
owner  and  user,  public  utility  corporation  and  pub- 
lic, is  one  of  the  most  intimate  and  vital  business 
relationships  to  be  found  in  the  country.    The  ques- 


146    DEPRECIATION   OF  PUBLIC  UTILITIES 

tions  at  issue  involve  not  thousands  of  dollars,  but 
thousands  of  millions  of  dollars.  Upon  their  right 
determination  depends  the  existence  and  usefulness 
of  the  utilities;  and  the  utilities  make  possible  our 
present-day  civilization. 


APPENDIX 

DEPRECIATION  IN  DECISIONS  OF  COURTS* 

A  STUDY  of  cases  bearing  upon  the  question  of 
depreciation  is  of  great  value  in  that  there  is  clearly 
reflected  in  the  opinions  of  the  courts  the  gradual 
development  of  the  subject  from  its  beginnings 
down  to  the  present  day. 

In  the  presentation  of  cases  in  the  following  pages 
a  strict  following  of  the  chronological  order  of  the 
decisions  has  been  adopted,  and  each  quotation  as 
given  is  complete  so  far  as  it  has  any  bearing  on 
the  subject. 

No  attempt  is  made  to  select  parts  of  decisions 
which  seem  to  support  the  contentions  which  the 
writer  has  advanced  in  the  foregoing  chapters. 

Such  notes  as  accompany  the  quotations  are  in- 
tended to  direct  attention  to  the  principal  features 
of  each  case  as  the  writer  sees  them. 

The  division  into  periods  is  purely  arbitrary,  but 
it  is  believed  it  will  be  helpful  in  reaching  a  full 
understanding  of  the  case. 

No  attempt  has  been  made  to  include  state  court 
cases  or  commission  decisions  except  as  a  few  of 
them  seem  to  have  special  historical  interest. 

•  Supreme  Court  and  United  States  Courts. 

147 


148    DEPRECIATION  OF  PUBLIC  UTILITIES 

The  great  volume  of  commission  and  court  de- 
cisions of  recent  years  are  so  fully  presented  and 
indexed  in  ''Public  Utilities  Reports,  Annotated," 
and  in  Whitten's  "Valuation  of  Public  Service 
Corporations,"  that  it  would  be  futile  to  do  any 
more  than  has  been  here  undertaken,  namely  to 
bring  out  the  history  of  depreciation  as  it  has  been 
written  by  the  courts  of  highest  jurisdiction. 

FIRST  PERIOD 

Early  Decisions  Bearing  on  Depreciation  Prior  to  the  Adoption 
OF  Uniform  Accounting 

The  earliest  cases  throwing  any  light  upon 
methods  of  maintenance  and  early  accounting  theo- 
ries touching  the  subject  of  depreciation  are  two 
cases  handed  down  at  the  same  time,  both  decided 
in  October,  1878  and  found  in  99  U.  S.  The  two 
must  be  read  together.  The  Union  Pacific  case 
treats  of  expenditures  properly  charged  against 
earnings.  The  Kansas  Pacific  case  disallows  a 
charge  to  operating  expenses  of  depreciation,  the 
charge  being  for  a  reserve  and  not  actually  ex- 
pended. 

Union  Pacific  Railroad  Company  vs  United 
States,  99  U.  S.  p.  402.  Decided  Oct.,  1878,  on  p. 
420,  Justice  Bradley : 

"having  considered  the  question  of  receipts  or  earnings,  the 
next  thing  in  order  is  the  expenditures  which  are  properly 
chargeable  against  the  gross  earnings  in  order  to  amve  at  the 
'net  earnings'  as  this  expression  is  to  be  understood  within  the 


APPENDIX  149 

meaning  of  the  act.  As  a  general  proposition,  net  earnings  are 
the  excess  of  the  gross  earnings  over  the  expenditures  defrayed 
in  producing  them,  aside  from,  and  exclusive  of,  the  exiJenditure 
of  capital  laid  out  in  constructing  and  equipping  the  works  them- 
selves. It  may  often  be  difficult  to  draw  a  precise  line  between 
expenditures  for  construction,  and  the  ordinary  exj^enses  incident 
to  operating  and  maintaining  the  road  and  works  of  a  railroad 
company.  Theoretically^  the  expenses  chargeable  to  earnings  in- 
clude the  general  expenses  of  keeping  up  the  organisation  of  the 
company  and  all  expenses  incurred  in  operating  the  works  and 
keeping  them  in  good  condition  and  repair;  whilst  expenses 
chargeable  to  capital  include  those  which  are  incurred  in  the 
original  construction  of  the  works,  and  the  subsequent  enlarge- 
ment and  improvement  thereof.  With  regard  to  the  last  men- 
tioned class  of  expenditures,  however,  namely,  those  which  are 
incuri'ed  in  enlarging  and  improving  the  works,  a  difference  of 
practice  prevails  amongst  railroad  companies.  Some  charge  to 
construction  account  every  item  of  expense,  and  every  part  and 
portion  of  every  item,  which  goes  to  make  the  road,  or  any  of  its 
appurtenances  or  equipment,  better  than  they  were  before ;  whilst 
others  charge  to  ordinary  expense  account,  and  against  earnings, 
whatever  is  taken  for  these  purposes  from  the  earnings,  and  is  not 
raised  upon  bonds  or  issues  of  stock.  The  latter  method  is 
deemed  the  most  conservative  and  beneficial  for  the  company,  and 
operates  as  a  restraint  against  injudicious  dividends  and  the 
accumulation  of  a  heavy  indebtedness.  The  temptation  is,  to 
make  expenses  appear  as  small  as  possible,  so  as  to  have  a  large 
apparent  surplus  to  divide.  But  it  is  not  regarded  as  the  wisest 
and  most  prudent  method.  The  question  is  one  of  policy,  which 
is  usually  left  to  the  discretion  of  the  directors.  .  .  .  But  for 
making  all  ordinary  improvements,  as  well  as  repairs,  it  is  better 
for  the  stockholders,  and  all  those  who  are  interested  in  the  pros- 
perity of  the  enterprise,  that  a  portion  of  the  earnings  should  be 
employed.  We  think  that  the  true  interest  of  the  government,  in 
this  case,  is  the  same  as  that  of  the  stockholders;  and  will  be 
subserved  by  encouraging  a  liberal  application  of  the  earnings 
to  the  improvements  of  the  works."     (Italics  ours.) 


150    DEPRECIATION  OF  PUBLIC  UTILITIES 

It  must  be  kept  in  mind  that  at  this  period  there 
was  no  governmental  control  exercised  except  in 
one  or  two  states.  * '  Injudicious  dividends, "  * '  heavy 
indebtedness,"  "to  make  apparent  surplus  to  di- 
vide," '*is  usually  left  to  the  directors,"  are  signifi- 
cant of  conditions  not  now  prevalent,  in  these  times 
of  regulation.  This  case  recognizes  the  keeping  the 
works  in  good  repair,  as  an  operating  expense.  This 
is  a  frank  recognition  of  the  propriety  of  charging 
operating  expenses  not  only  with  '* repairs"  but 
also  with  ''all  ordinary  improvements." 

United  States  vs  Kansas  Pacific  Railway  Com- 
pany, 99  U.  S.  p.  455.    Decided  October,  1878. 

In  this  case  the  court  refers  to  the  rule  for  de- 
termination of  net  earnings  as  announced  in  Union 
Pacific  Railroad  vs  United  States  and  says,  p.  459: 

"It  is  proper,  however,  before  concluding,  that  we  should  indi- 
cate our  opinion  with  regard  to  certain  classes  of  expenditures  on 
which  the  government  and  the  company  are  at  issue." 

The  former  insists  that  certain  items  should  be 
excluded  from  the  account  which  are  claimed  by  the 
latter  to  be  legitimate.  These  items  are  designated 
in  Schedule  C,  annexed  to  the  findings  of  the  court 
below  and  are  as  follows : 

^'First.  'Depreciation  account  or  expense  not  charged  up.* 
This  is  explained  to  he  the  amount  necessary  to  put  the  road  in 
proper  repair,  hut  which  was  not  actually  expended  for  that  pur- 
pose.  We  are  clearly  of  the  opinion  that  it  is  not  a  proper 
charge.  Only  such  expenditures  as  are  actually  made  can  with 
any  propriety  he  claimed  as  a  deduction  from  earnings. 


APPENDIX  151 

"Second.  'Construction  account  or  improvements  and  additions 
to  track,'  etc.  This  item,  according  to  what  we  have  said  in  the 
Union  Pacific  Railroad  case,  ought  to  be  allowed. 

"Thirdly.  'Equipment  account,  or  replacing  and  rebuilding 
rolloing  stock,  machinery,  etc'  This  item  should  also  be  allowed 
as  an  expenditure  properly  chargeable  to  the  earnings  of  the  road 
when  actually  paid  out  of  earnings  and  not  raised  by  the  issue  of 
bonds  or  stock. 

''Fourthly.  'Real  estate  purchased  for  depot  grounds,  etc.,  and 
expense  of  same.'  This  item  is  a  proper  charge  if  actually  paid 
out  of  the  earnings,  and  not  raised  by  bonds  or  stock."  (Italics 
ours.) 

This  case  clearly  and  unequivocally  disapproved 
of  the  creation  of  a  reserve  and  the  charging  to  oper- 
ating expenses  of  an  allowance  which  was  not  ex- 
pended during  the  year.  Undoubtedly  in  view  of 
conditions  as  to  lack  of  control  existing  at  the  time 
it  was  a  wise  precaution.  It  will  be  noted  that  under 
modern  accounting  the  second  item  would  be  an  ad- 
dition (capital)  while  the  third  is  clearly  a  replace- 
ment, and  the  fourth  an  addition  to  capital.  The 
interesting  thing  about  these  two  cases  is  the  great 
laxity  of  accounting  methods  which  prevailed  at  the 
time. 

Eight  years  later,  in  the  October  term,  1886,  in 
New  York,  Lake  Erie  and  Western  Railroad  vs 
Nickals,  119  U.  S.  p.  296,  the  court  says  on  p.  306: 

"A  different  view  would  lead  to  results  which  sound  policy 
would  seem  to  forbid,  and  which,  therefore,  it  is  not  to  be  sup- 
posed were  contemplated  by  the  parties.  For,  if  preferred  stock- 
holders become  entitled  to  dividends  upon  a  mere  ascertainment 
of  profits  for  a  particular  year,  the  duty  of  the  company  to  mair^ 
tain  its  track  and  cars  in  such  condition  as  to  accommodate  the 


152    DEPRECIATION   OF  PUBLIC   UTILITIES 

public  and  provide  for  the  safe  transportation  of  passengers  and 
freight  would  be  subordinate  to  their  right  to  payment  out  of  the 
funds  remaining  on  hand  after  meeting  current  expenses  and 
fixed  charges."     (Italics  ours.) 

This  decision  is  cited  as  an  early  recognition  of 
the  duty  of  the  company  to  maintain  its  property  as 
being  paramount  to  the  right  of  preferred  stock- 
holders to  demand  dividends,  and  is  quoted,  not  as 
directly  bearing  on  the  subject  of  depreciation,  but 
as  showing  early  recognition  of  the  method  of  keep- 
ing up  the  property  by  direct  replacement. 

Mackintosh  vs  Flint  and  Pere  Marquette  Rail- 
ivay,  34  Fed.  583.  Decided  March,  1888  by  Judge 
Jackson,  afterward  Justice  Jackson  of  the  Supreme 
Court.  On  p.  601,  speaking  of  the  limitations  upon 
the  company  and  its  directors  placed  by  charter  and 
mortgage  agreement,  the  court  says: 

"They  were  entitled,  as  between  the  two  sets  of  stockholders, 
to  employ  the  net  income  in  paying  interest  on  prior  bonds,  old 
or  new ;  in  making  repairs  on  the  road,  buildings,  and  other  prop- 
erty of  the  company  so  as  to  maintain  their  efficiency;  and  in 
meeting  the  expenses  of  equipment  and  renewals,  which  evidently 
refers  to  repairs  upon  and  keeping  up  the  rolling  stock  of  the 
company,  but  does  not  include  the  purchase  of  new  equipment." 
(Italics  ours.) 

The  decision  deals  in  many  figures  and  a  resume 
of  many  of  the  facts.  On  p.  608  the  judge  summar- 
izes several  pages  as  follows : 

"If  the  whole  cost  of  the  steel  rail  betterments  placed  upon  the 
road  had  been  charged  to  construction  account,  as  it  properly 


APPENDIX  153 

should  have  been,  as  between  the  two  sets  of  stockholders,  then 
the  two  items  making  up  this  aggregate  of  $88,890  might  i^rop- 
erly  have  been  borne  by  earnings  as  an  operating  expense;  but, 
instead  of  doing  this,  the  roadbed,  or  track,  is  improved  by  sub- 
stituting new  steel  rails  for  old  iron  rails;  the  difference  in  their 
value  is  charged  to  operating  expense,  and  taken  out  of  earnings; 
and  then,  when  the  old  rail  is  used  for  sidings  and  spurs,  it  is 
charged  sometimes,  when  the  management  think  proper  and  so 
direct,  to  construction,  and  at  other  times  no  charge  is  made  to 
construction,  and  the  whole  expense  of  the  change  ...  is  made 
to  fall  upon  the  earnings.  .  .  . 

"Its  effect  was  not  to  keep  the  track  in  repair — in  the  same 
state  of  efficiency  as  it  existed  in  on  Oct.  1,  1880 — but  to  improve 
and  enhance  its  value  at  the  expense  of  earnings,  which  are  thus 
reduced."     (Italics  ours.) 

This  decision  is  of  interest  as  an  early  recogni- 
tion of  the  distinction  between  maintenance  ex- 
penses chargeable  to  earnings  and  additions  to 
property  chargeable  to  capital;  and  especially  in 
that  it  holds  that  the  property  is  to  be  held  "in  the 
same  state  of  efficiency"  as  existed  eight  years  be- 
fore, through  maintenance.  This  case  did  not  reach 
the  higher  court. 

Reagan  vs  Farmers'  Loan  and  Trust  Company, 
154  U.  S.  p.  362.    Justice  Brewer  says,  p.  407,  1894 : 

"Again  the  sum  of  $302,085.77  appears  in  that  table  under  the 
description  'cost  of  road,  equipment  and  permanent  improve- 
ments, admitted  to  have  been  included  in  operating  exj^enses,'  and 
is  added  to  the  income  as  though  it  had  been  improperly  included 
in  operating  expenses.  But  before  this  charge  can  be  held  to  be 
proper,  it  is  well  to  see  what  further  light  is  thrown  on  the  matter 
by  other  portions  of  the  report.  That  states  that  there  were  no 
extensions  of  the  road  during  that  year,  so  that  all  of  this  sum 
was  expended  on  the  road  as  it  was.    Among  the  items  that  go  to 


154    DEPRECIATION  OF  PUBLIC  UTILITIES 

make  up  this  sum  of  $302,085.77  is  one  of  $113,212.99  for  rails, 
and  it  appears  from  the  same  report  that  there  was  not  a  dollar 
expended  for  rails  except  as  included  within  this  amount.  Now, 
it  goes  without  saying  that  in  the  operation  of  every  road  there 
is  a  constant  wearing  out  of  rails  and  a  constant  necessity  for 
replacing  old  with  new.  The  purchase  of  these  rails  may  be  called 
permanent  improvements,  or  by  any  other  name,  but  they  are 
what  is  necessary  for  keeping  the  road  in  serviceable  condition.. 
Indeed,  in  another  part  of  the  report,  under  the  head  of  'renewal 
of  rails  and  ties,'  is  stated  the  number  of  tons  of  'new  rail  laid' 
on  the  main  line.  Other  items  therein  are  for  fencing,  grading, 
bridging  and  culvert  masonry,  bridges  and  trestles,  buildings, 
furniture,  fixtures,  etc.  It  being  shown  affirmatively  that  there 
were  no  extensions,  it  is  obvious  that  these  expenditures  were 
those  necessary  for  a  proper  carrying  on  of  the  business  required 
of  the  company.  .  .  .  Those  are  facts  whose  significance  cannot 
be  destroyed  by  any  mere  manner  of  bookkeeping  or  classification 
of  expenditures."     (Italics  ours.) 

This  case  is  directly  in  line  with  the  foregoing 
cases  and  shows  that  the  maintenance  of  property 
in  serviceable  condition  is  to  be  through  charges  to 
operating  expenses — the  Replacement  method  of 
accounting  for  depreciation. 

Southern  Pacific  Railroad  Company  vs  Board  of 
Railroad  Commissions,  78  Fed.  236,  1896,  quotes 
approvingly  from  Justice  Brewer  in  the  Reagan 
case  and  Justice  Bradley  in  Union  Pacific  Railroad 
vs  United  States,  cites  numerous  other  cases  and 
approves  the  charging  of  the  same  class  of  improve- 
ments to  operating  expenses.  There  are  other  cases 
cited  in  this  decision  which  are  not  at  all  at  variance 
with  the  doctrine  laid  down  in  1878. 

One  of  the  most  interesting  cases  of  those  de- 
cided prior  to  1909  was  that  of  San  Diego  Water 


APPENDIX  155 

Company  vs  San  Diego,  a  California  case.  This 
marks  the  first  appearance  of  the  argument  for  an 
annual  allowance  for  replacement.  While  the  case 
has  no  present  weight  in  the  light  of  more  recent 
and  authoritative  opinions,  it  is  of  decided  histor- 
ical value.  It  is  of  great  interest  also  on  account 
of  the  dissenting  opinion  of  Chief  Justice  Beatty 
which  was  at  least  ten  years  in  advance  of  the  trend 
of  judicial  opinion. 

San  Diego  Water  Company  vs  San  Diego,  118 
Cal.  556,  Oct.,  1897.  Justice  Van  Fleet  says,  on  p. 
574: 

"With  regard  to  the  question  of  the  depreciation  of  the  plant 
by  use,  it  is  sufficient  to  say  that  ordinary  repairs  should  be 
charged  to  current  expenses,  that  substantial  reconstruction  or 
replacement  should  be  charged  to  the  construction  account,  and 
that  depreciation  should  not  otherwise  be  considered.  It  is  doubt- 
less difficult  in  many  cases  to  properly  discriminate  between  cur- 
rent and  ordinary  repairs,  and  such  repairs  as  amount  in  effect 
to  new  construction.  Such  difficulties  when  they  arise,  must  be 
solved  by  the  application  of  principles  on  which  ordinary  busi- 
ness enterprises  are  conducted." 

Justice  Garouette,  in  a  concurring  opinion  says: 

"This  balance  of  $25,000  is  profit,  unless  it  is  swallowed  up  by 
the  finding  of  the  court  that  plaintiff's  plant  suffered  an  annual 
depreciation  of  three  and  one  half  per  cent,  and  the  conclusion 
of  law  therefrom  that  a  percentage  upon  the  investment  to  that 
amount  should  be  added  to  the  operating  expenses  before  the 
point  is  reached  where  profit  begins.  We  are  satisfied  that  this 
finding  has  no  support  in  the  evidence,  even  conceding  the  con- 
clusion of  law  drawn  therefrom  is  sound.  In  the  first  place,  the 
evidence  develops  that  there  can  be  no  general  depreciation  of 


156    DEPRECIATION  OF  PUBLIC  UTILITIES 

this  plant  as  a  whole.  There  are  tunnels,  wells,  reservoirs,  water 
rights  and  real  estate,  amounting  to  more  than  one-half  the 
valuation  of  the  plant.  There  is  no  depreciation  of  these  things; 
there  is  no  wear  and  tear,  no  permanent  and  gradual  destruction 
by  use  and  age.    Most  of  them  stand  everlasting  as  the  hills. 

"The  theory  of  the  plaintiff  in  this  regard  seems  to  be  that  the 
life  of  a  plant  of  this  character  may  be  approximated  at  thirty 
years,  and  that  a  sinking  fund  of  one-thirtieth  of  its  value  should 
be  collected  from  the  rate  payers  annually  and  laid  aside  to  be 
handed  to  the  stockholders  upon  the  sad  occasion  of  its  demise,  as 
an  alleviating  salve  to  their  sorrow.  But  such  a  thing  is  all 
wrong,  for  it  results  in  the  consumers  of  water  buying  the  plant 
and  paying  for  it  in  annual  installments.  Consumers  of  water 
cannot  be  charged  with  the  cost  of  construction.  They  are  only 
to  pay  a  fair  interest  upon  such  costs;  and  as  we  look  at  this 
matter,  if  this  3^  per  cent  is  not  stowed  away  in  the  vaults 
as  a  sinking  fund  to  make  glad  the  hearts  of  the  stockholders 
upon  the  expiration  of  thirty  years,  which  theory  cannot  be 
tolerated  for  a  moment,  then  it  must  go  into  the  plant  as  cost 
of  construction,  and,  therefore,  not  chargeable  against  the  con- 
sumers. The  result  of  such  expenditure  is  only  to  increase  the 
valuation  of  the  plant  and  to  thereby  draw  from  the  consumers  an 
income  upon  the  amount  of  the  investment.  If  improvements  are 
made  in  the  plant,  the  cost  of  these  imiirovements  should  be 
charged  against  the  construction  account.  If  repairs  are  made  in 
the  plant  as  it  stands,  as  for  example,  a  new  pipe  substituted  for 
an  old  piece  of  the  same  size  and  quality,  such  charge  should  be 
considered  operating  expenses.  ...  In  cases  of  the  present  char- 
acter under  the  head  of  operating  expenses  the  company  is  en- 
titled to  charge  for  keeping  the  plant  in  its  normal  condition ;  and 
the  sinking  of  new  wells,  the  building  of  new  reservoirs,  the  erec- 
tion of  additional  buildings,  and  the  substitution  of  larger  and 
better  pipe  (to  the  extent  of  the  difference),  do  not  come  under 
the  head  of  operating  expenses,  but  should  be  charged  to  con- 
struction accounts." 

Chief  Justice  Beatty  in  the  same  case,  in  a  dis- 
senting opinion  said  on  p.  588: 


APPENDIX  157 

"Rates  ought  to  be  adjusted  to  the  value  of  the  service  ren- 
dered, and  this  means  that  the  water  companies  should  be  allowed 
to  collect  annually  a  gross  income  sufficient  to  pay  current  ex- 
penses, maintain  the  necessary  plant  in  a  state  of  efficiency,  and 
declare  a  dividend  to  stockholders  equal  to  at  least  the  lowest 
current  rates  of  interest,  not  on  the  par  or  market  value  of  the 
stock,  but  on  the  actual  value  of  the  property  necessarily  used  in 
providing  and  distributing  the  water  to  consumers."  *  *  * 

"As  to  current  expenses,  all  operating  expenses  reasonably  and 
properly  incurred  should  be  allowed,  taxes  should  be  allowed,  and 
the  cost  of  current  repairs. 

''In  addition  to  this  if  there  is  any  part  of  the  plant,  such  as 
main  pipe,  etc.,  which  at  the  end  of  a  term  of  years — twenty  years 
for  instance,  will  be  so  decayed  and  worn  out  as  to  require 
restoration — an  annual  allowance  should  be  made  for  a  sinking 
fund  sufficient  to  replace  such  part  of  the  plant  when  it  is  worn 
out."     (Italics  ours.) 

Judge  Beatty's  opinion  is  substantially  in  line 
with  the  Knoxville  decision  which  was  rendered 
twelve  years  later,  and  is  the  first  recognition  by  any 
of  the  courts  of  the  propriety  of  setting  aside  an 
annual  allowance  for  the  replacement  of  parts  of  the 
plant  when  worn  out.  Thus  during  the  nineteen 
years  from  Oct.,  1878  to  Oct.,  1897  the  law  as  laid 
down  by  Justice  Bradley  in  United  States  vs  Kansas 
Pacific  Railway,  99  U.  S.  455,  was  accepted. 

Brymer  vs  Butler  Water  Company,  179  Pa.  State 
231,  Jan.  4,  1897.    Justice  Williams  says  on  p.  251 : 

"They  are  entitled  to  a  rate  of  return,  if  their  property  will 
earn  it,  not  less  than  the  legal  rate  of  interest;  and  a  system  of 
charges  that  yields  no  more  income  than  is  fairly  required  to 
maintain  the  plant,  pay  fixed  charges  and  operating  expenses, 
provide  a  suitable  sinking  fund  for  the  payment  of  debts,  and  pay 
a  fair  profit  to  the  owners  of  the  property,  cannot  be  said  to  be 


158    DEPRECIATION   OF  PUBLIC   UTILITIES 

unreasonable.  .  .  .  The  cost  of  the  water  to  the  company  includes 
a  fair  return  to  the  persons  who  furnished  the  capital  for  the 
construction  of  the  plant,  in  addition  to  an  allowance  annually  of 
a  sum  sufficient  to  keep  the  plant  in  good  repair  and  to  pay  any 
fixed  charges  and  operating  expenses,"     (Italics  ours.) 

In  this  case  there  is  the  possible  suggestion  of  a 
depreciation  allowance.  It  certainly  clearly  allows 
for  the  method  of  "maintenance,"  or  direct  replace- 
ment. 

Redlands,  etc.,  Water  Company  vs  Redlands,  121 
Cal.  312.    June  29, 1898.    Sijllabus: 

"In  a  municipal  ordinance  fixing  rates  .  .  .  the  water  company 
is  not  entitled  to  be  reimbursed  from  the  income  derived  from 
rates  fixed  by  the  ordinance  for  interest  upon  its  indebtedness, 
nor  for  depreciation  of  its  plant,  aside  from  the  amount  requisite 
for  its  maintenance  and  repairs  during  the  year."     (Italics  ours.) 

This  case  followed  and  referred  to  the  San  Diego 
case. 

Milwaukee  Electric  Railway  and  Light  Company 
vs  Milwaukee,  87  Fed.  577,  May  31,  1898,  District 
Judge  Seaman  on  p.  582,  says : 

"However  valuable  this  testimony  is  for  analysis  of  the  book- 
keeping methods  and  for  correction  of  certain  charges,  it  is 
clearly  insufficient,  without  other  support  to  contradict  the  un- 
disputed testimony,  both  positive  and  expert,  on  the  part  of  com- 
plainant, which  verifies  substantially  its  contention  upon  the  dis- 
puted subjects  of  deduction,  namely,  that  the  expenditures  so 
charged  were  largely,  if  not  wholly,  of  such  nature  as  to  justify 
deduction  for  'maintenance';  and  that  depreciation  is  a  well 
recognized  fact  in  all  such  plants,  for  which  allowance  must  he 
made  to  save  the  capital  from  impairment,  without  any  question 
of  its  entry  upon  the  books."     (Italics  ours.) 


APPENDIX  159 

The  court  quotes  witness  Beggs  at  some  length 
on  p.  583  as  to  depreciation,  showing  that  about 
twelve  miles  of  track  per  year  must  be  recon- 
structed completely  and  that  twenty  car  bodies  per 
year  must  replace  old  bodies  "to  keep  the  property 
up  to  standard." 

The  court  concludes  that  depreciation  is  an  ele- 
ment to  be  taken  into  account  before  it  can  be  de- 
termined that  earnings  are  excessive,  but  holds  that 
the  final  determination  of  the  question  is  not  neces- 
sary in  this  case.  He  says  "depreciation  is  an  im- 
portant factor  of  safety  in  either  view." 

San  Diego  Land  and  Town  Company  vs  National 
City,  174  U.  S.  739.  Decided  May  22,  1899.  Justice 
Harlan  says  on  p.  757 : 

"The  contention  of  the  appellant  in  the  present  case  is  that  in 
determining  what  are  just  rates  the  courts  should  take  into  con- 
sideration the  cost  of  its  plant;  the  cost  per  annum  of  operating 
the  plant,  including  interest  paid  on  money  borrowed  and  reason- 
ably necessary  to  be  used  in  constructing  the  same;  the  annual 
depreciation  of  the  plant  from  natural  causes  resulting  from  its 
use;  and  a  fair  profit  to  the  company  over  and  above  such  charges 
for  its  services  in  supplying  the  water  to  consumers,  either  by 
way  of  interest  on  the  money  it  has  expended  for  the  public  use, 
or  upon  some  other  fair  and  equitable  basis.  Undoubtedly,  all 
these  matters  ought  to  be  taken  into  consideration,  and  such 
weight  be  given  them,  when  rates  are  being  fixed,  as  under  all  the 
circumstances  will  be  just  to  the  company  and  the  public." 
(Italics  ours.) 

San  Diego  Land  and  Town  Company  vs  Jasper, 
189  U.  S.  439.  Decided  April  6,  1903.  Justice 
Holmes  refers  to  depreciation  in  a  line  on  p.  446  as 
follows : 


160    DEPRECIATION  OF  PUBLIC  UTILITIES 

"We  will  say  a  word  about  the  opposite  contention  of  the 
appellant,  that  there  should  have  been  an  allowance  for  deprecia- 
tion over  and  above  an  allowance  for  repairs.  From  a  constitu- 
tional point  of  view  we  see  no  sufficient  evidence  that  the  allow- 
ance of  six  per  cent  on  the  value  set  by  the  supervisors,  in  addi- 
tion to  what  was  allowed  for  repairs,  is  confiscatory.  On  the 
other  hand,  if  the  claim  is  made  under  the  statute,  although  that 
would  be  no  ground  for  bringing  the  case  to  this  court,  it  has 
been  decided  by  the  Supreme  Court  of  California  that  the  statute 
warrants  no  such  claim," 

While  neither  of  these  cases  is  of  special  impor- 
tance as  far  as  throwing  any  light  on  the  proper 
disposition  of  the  subject  of  depreciation,  both  refer 
to  it  and  it  is  clear  that  in  the  1903  case  contention 
was  made  for  a  depreciation  allowance.  The  im- 
portant thing  is  to  note  the  lack  of  appreciation  of 
the  importance  of  the  subject  as  late  as  1903.  It  is 
evident  that  the  so-called  "depreciation  accounting" 
which  may  properly  be  called  the  waterworks  plan, 
had  not  secured  recognition  from  the  courts. 

PerMns  vs  Northern  Pacific  Railway,  155  Fed. 
445.  Circuit  Court  Minnesota.  Sept.  23,  1907.  Dis- 
trict Judge  Lochren  says  on  p.  451 : 

".  .  .  and  the  showing  was,  in  some  cases,  that  there  were  no 
charges  made,  in  the  keeping  of  the  accounts,  under  the  head  of 
for  or  on  account  of  depreciation  in  the  road  or  rolling  stock, 
the  property  of  the  company.  It  is  evident  that  there  ought  to 
be  a  proper  account  under  that  head;  that  a  railroad,  like  every- 
thing else,  will  wear  out  in  time,  and  they  have  been  used  so  long 
in  this  country  that  there  can  be  a  reasonable  estimate  of  the 
percentage  of  loss  each  year  from  depreciation  of  the  roadbed, 
culverts,  bridges,  rolling  stock;  that  it  would  he  proper  to  lay 
aside  a  reasonable  amount  to  furnish  replacements,  renewals,  and 


APPENDIX  161 

repairs  when  needed;  and  that  if  that  was  not  done  the  railroad 
company  might  soon  be  in  a  position  in  which  it  could  not  keep 
up,  with  the  receipts  that  it  was  getting,  and  maintain  its  prop- 
erty in  an  efficient  state  to  render  such  service  as  the  public  is 
entitled  to  receive  from  it.  Now  this  is  a  matter  in  which  the 
public  has  an  interest,  as  well  as  the  railroad  companies  and  the 
stockholders  of  the  railroad  companies. 


"There  is  a  danger  that  this  feeling  of  selfishness  may  lead  them 
too  far,  and  reduce  this  compensation  so  much  that  it  will  not 
enable  the  railroads  to  serve  them  with  efficiency — to  keep  up 
their  roadbed,  culverts,  bridges,  and  everything  so  that  they  will 
be  entirely  safe  for  the  transportation  of  passengers  and  freight, 
and  to  keep  the  rolling  stock  in  the  best  state  of  efficiency  and 
enable  them  to  provide  the  best  service  attainable.  And  that 
is  exactly  what  those  corporations  are  required  to  do.  They 
are  required  to  exercise  the  highest  degree  of  care  in  relation  to 
the  transportation  of  passengers,  and  a  high  degree  of  care  in 
relation  to  the  transportation  of  freight,  and  it  is  certainly  for 
the  interests  of  the  people  that  they  should  be  enabled  to  do  this ; 
and  it  would  be  a  very  short  sighted  policy  which  would  reduce 
the  compensation  of  these  railroads  to  a  degree  that  would  dis- 
able them  from  performing  these  services  fully  and  fairly  for 
the  benefit  of  the  people."     (Italics  ours.) 

This  case  is  specially  interesting  as  it  makes  the 
suggestion  of  the  propriety  of  the  establishment  of 
reserves,  if  not  for  depreciation,  at  least  to  equalize 
expenditures  between  good  years  and  lean  ones.  It 
again  lays  stress  on  the  obligation  resting  on  the 
road  to  maintain  its  property  in  the  ''best  state  of 
efficiency  and  enable  them  to  provide  the  best  service 
attainable. ' ' 

The  cases  that  have  been  cited  cover  all  of  the 
more  important  rulings  of  the  courts  on  the  subject 


162    DEPRECIATION  OF  PUBLIC  UTILITIES 

of  depreciation  from  the  beginning  of  our  history- 
down  to  1907,  the  first  year  of  the  operation  of  the 
uniform  accounting  law,  and  with  the  exception  of 
a  few  state  court  cases  all  have  been  referred  to. 

The  points  which  it  is  desired  to  emphasize  by 
this  rather  extended  series  of  references  are  as  fol- 
lows : 

There  was  no  clear  recognition  by  either  courts, 
attorneys,  accountants  or  operating  officials  of  the 
necessity  of  providing  for  depreciation  by  the  crea- 
tion of  an  annual  allowance,  although  in  some  of  the 
cases  this  was  contended  for. 

There  is  an  unequivocal  recognition  of  the  wear- 
ing out  of  property,  of  the  necessity  for  its  replace- 
ment and  maintenance,  and  of  the  duty  of  the  utility 
to  maintain  its  property  in  serviceable  condition. 

As  the  cases  progress,  there  is  a  growing  recog- 
nition of  the  necessity  for  separating  capital  ex- 
penditure from  maintenance  expenditures. 

It  must  be  borne  in  mind  that  these  cases  cover 
the  period  from  the  beginning  of  all  utilities  down 
to  within  fifteen  years,  and  that,  taken  together,  or 
singly,  no  argument  can  be  drawn  from  them  that 
any  deduction  from  actual  investment  remaining  in 
the  property  at  the  date  of  investigation  should  be 
made,  nor  can  it  be  argued  that  an  annual  allow- 
ance should  be  set  up  and  charged  to  operating  ex- 
pense, a  thing  that  was  specifically  forbidden  in  the 
Kansas  Pacific  case. 

The  recognition  of  the  method  of  the  maintenance 
of  the  condition  of  the  property  through  renewal  of 
parts  as  they  wear  out  may  be  seen  throughout  this 


APPENDIX  163 

line  of  decisions,  and  it  is  clear  that  the  so-called 
replacement  method  of  accounting  for  renewals  has 
the  tacit  approval  of  the  courts  during  all  of  the 
period,  although  no  such  name  was  applied  to  it. 

SECOND  PERIOD 

Decisions  Bearing  on  Depreciation  Following  the  Adoption  op 
Uniform  Accounting 

The  most  important  decision  yet  rendered  on  the 
subject  of  depreciation  is  that  of  Justice  Moody  in 
the  Knoxville  case.  It  should  be  borne  in  mind  in 
reading  this,  or  any  other  decision,  that  the  im- 
mediate facts,  as  brought  out  by  the  proof  in  the 
case,  have  much  bearing  on  the  proper  interpreta- 
tion to  be  given  the  decision.  It  is  believed  desir- 
able to  give  a  somewhat  more  full  quotation  from 
this  case  than  is  usually  done  in  order  to  bring  out 
some  of  the  facts. 

City  of  Knoxville  vs  Knoxville  Water  Company, 
212  U.  S.  1.  Decided  Jan.  4,  1909.  Justice  Moody 
says  on  p.  9 : 

"The  cost  of  reproduction  is  one  way  of  ascertaining  the  pres- 
ent value  of  a  plant  like  that  of  a  water  company,  but  that  test 
would  lead  to  obviously  incorrect  results,  if  the  cost  of  reproduc- 
tion is  not  diminished  by  the  depreciation  which  has  come  from 
age  and  use.  The  company  contends  that  the  master,  in  fixing 
upon  the  valuation  of  the  tangible  property,  did  make  an  allow- 
ance for  depreciation,  but  we  are  unable  to  agree  to  this.  The 
master  nowhere  says  that  he  made  allowance  for  depreciation 
and  the  language  of  his  report  is  inconsistent  with  such  a  reduc- 
tion.   The  figures  which  he  adopts  are  those  of  a  'fair  contractor's 


164    DEPRECIATION  OF  PUBLIC  UTILITIES 

price.'  The  basis  of  his  calculation  was  the  testimony  of  an 
opinion  witness  called  by  the  company.  That  witness  submitted 
a  table,  which  avowedly  showed  the  cost  of  reproduction,  without 
allowance  for  depreciation.  The  values  testified  to  by  him  were 
adopted  by  the  master  in  a  great  majority  of  cases.  The  witness's 
valuation  of  the  tangible  property  was  somewhat  reduced  by  the 
master,  but  the  reductions  were  not  based  on  the  theory  of  de- 
preciation, but  upon  a  difference  of  opinion  as  to  the  reproduction 
cost. 

"The  cost  of  reproduction  is  not  always  a  fair  measure  of  the 
present  value  of  a  plant  which  has  been  in  use  for  many  years. 
The  items  composing  the  plant  depreciate  in  value  from  year  to 
year  in  a  varying  degree.  Some  pieces  of  property,  like  real 
estate  for  instance,  depreciate  not  at  all,  and  sometimes,  on  the 
other  hand,  appreciate  in  value.  But  the  reservoirs,  the  mains, 
the  service  pipes,  stmctures  upon  real  estate,  standpipes,  pumps, 
boilers,  meters,  tools  and  appliances  of  every  kind  begin  to  de- 
preciate with  more  or  less  rapidity  from  the  moment  of  their 
first  use.  It  is  not  easy  to  fix  at  any  given  time  the  amount  of 
depreciation  of  a  plant  whose  component  parts  are  of  different 
ages  with  different  expectation  of  life.  But  it  is  clear  that  some 
substantial  allowance  for  depreciation  ought  to  have  been  made 
in  this  case.  The  officers  of  the  company,  alio  intuituo,  estimated 
what  they  called  'incomplete  depreciation'  of  this  plant  (which 
we  understand  to  be  the  depreciation  of  the  sun'iving  parts  of  it 
still  in  use)  at  $77,000,  which  is  14  per  cent  of  the  master's  ap- 
praisement of  the  tangible  property. 

"A  witness  called  by  the  city  placed  the  reproduction  value  of 
the  tangible  property  at  $363,000,  and  estimated  the  allowance 
that  should  be  made  for  depreciation  at  $118,000,  or  32  per  cent. 
In  the  view  we  take  of  the  case  it  is  not  necessary  that  we  should 
undertake  the  difficult  task  of  determining  exactly  how  much  the 
master's  valuation  of  the  tangible  property  ought  to  have  been 
diminished  by  the  depreciation  which  that  property  had  under- 
gone. It  is  enough  to  say  that  there  should  have  been  a  consider- 
able diminution,  sufficient  at  least  to  raise  the  net  income  found 
by  the  court  above  6  per  cent  upon  the  whole  valuation  thus 
diminished." 


APPENDIX  165 

and  again  on  p.  13 : 

"The  company's  original  ease  was  based  upon  an  elaborate 
analysis  of  the  cost  of  construction.  To  arrive  at  the  present 
value  of  the  plant  large  deductions  were  made  on  account  of  the 
depreciation.  This  depreciation  was  divided  into  complete  de- 
preciation and  incomplete  depreciation.  The  complete  deprecia- 
tion represented  that  part  of  the  original  plant  which  through 
destruction  or  obsolescence  had  actually  perished  as  useful  prop- 
erty. The  incomplete  depreciation  represented  the  impairment  in 
value  of  the  parts  of  the  plant  which  remained  in  existence  and 
were  continued  in  use.  It  was  urgently  contended  that  in  fixing 
upon  the  value  of  the  jjlant  ujDon  which  the  company  was  entitled 
to  earn  a  reasonable  return  the  amounts  of  complete  and  incom- 
plete depreciation  should  be  added  to  the  present  value  of  the 
surviving  parts.  The  court  refused  to  approve  this  method,  and 
we  think  properly  refused.  A  water  jDlant,  with  all  its  additions, 
begins  to  depreciate  in  value  from  the  moment  of  its"  use.  Before 
coming  to  the  question  of  profit  at  all  the  company  is  entitled  to 
earn  a  sufficient  sum  annually  to  provide  not  only  for  current 
repairs  hut  for  making  good  the  depreciation  and  replacing  the 
parts  of  the  property  when  they  come  to  the  end  of  their  life. 
The  company  is  not  hound  to  see  its  property  gradually  waste, 
without  making  provision  out  of  earnings  for  its  replacement. 
It  is  entitled  to  see  that  from  earnings  the  value  of  the  property 
invested  is  kept  unimpaired,  so  that  at  the  end  of  any  given  term 
of  years  the  original  investment  remains  as  it  was  at  the  begin- 
ning. It  is  not  only  the  right  of  the  company  to  make  such  a  pro- 
vision, but  it  is  its  duty  to  its  bond  and  stockholders,  and,  in  the 
case  of  a  public  service  corporation  at  least,  its  plain  duty  to  the 
public.  If  a  different  course  were  pursued  the  only  method  of 
providing  for  replacement  of  property  which  has  ceased  to  be 
useful  would  be  the  investment  of  new  capital  and  the  issue  of 
new  bonds  or  stocks.  This  course  would  lead  to  a  constantly 
increasing  variance  between  present  value  and  bond  and  stock 
capitalization — a  tendency  which  would  inevitably  lead  to  dis- 
aster either  to  the  stockholders  or  to  the  public,  or  both.  If, 
however,  a  company  fails  to  perform  this  plain  duty  and  to  exact 


166    DEPRECIATION  OF  PUBLIC   UTILITIES 

sufficient  returns  to  keep  the  investment  unimpaired,  whether  this 
is  the  result  of  unwarranted  dividends  upon  over-issues  of  securi- 
ties, or  of  omission  to  exact  proper  prices  for  the  output,  the 
fault  is  its  own.  When,  therefore,  a  public  regulation  of  its 
prices  comes  under  question  the  true  value  of  the  property  then 
employed  for  the  purpose  of  earning  a  return  cannot  be  enhanced 
by  a  consideration  of  the  errors  in  management  which  have  been 
committed  in  the  past."     (Italics  ours.) 

A  careful  study  of  this  case  in  all  its  phases  seems 
to  justify  the  following  conclusions: 

(a)  The  depreciation  to  be  deducted  is  loss  of 
value,  and  only  loss  of  value.  The  unusual  division 
into  complete  and  incomplete  depreciation  and  the 
equally  unusual  claim  that  these  amounts  should  be 
''added  to  the  present  value  of  the  surviving  parts," 
makes  clear  that  the  question  at  issue  was  the  in- 
clusion or  exclusion  of  these  amounts  in  the  value 
to  be  found.  They  were  excluded.  The  complete 
depreciation  was  ''that  part  of  the  original  plant 
which  through  destruction  and  obsolescence  had 
actually  perished  as  useful  property."  The  incom- 
plete depreciation  was  "impairment  in  value"  of 
the  remaining  plant.  Both  clearly  loss  of  value. 
This  finding  coupled  with  the  clear  statement  that 
the  duty  of  the  owner  is  to  "keep  the  investment 
unimpaired,"  "so  that  the  original  investment  re- 
mains as  it  was  in  the  beginning,"  clearly  bar  out 
any  deductions  from  the  appraisal  except  those  that 
constitute  loss  of  value,  and  such  loss  of  value  as 
can  be  restored. 

{h)  Depreciation  is  an  operating  expense.  The 
company  is  to  make  provision  "out  of  earnings"  for 


APPENDIX  167 

the  replacement  of  property.  ' '  If  a  different  course 
were  pursued  the  only  method  of  providing  for  re- 
placement of  property  .  .  .  would  be  the  investment 
of  new  capital. ' ' 

(c)  The  maintenance  of  the  integrity  of  the  in- 
vestment is  sought.  The  method  of  maintenance 
while  not  specifically  laid  down  is  indicated  to  be 
**to  provide  not  only  for  current  repairs  but  for 
making  good  the  depreciation  and  replacing  the 
parts  of  the  property  when  they  come  to  the  end 
of  their  life."  This  clause,  and  the  further  reitera- 
tion of  the  word  ''replacement"  would  indicate  that 
any  proper  method  which  may  be  devised  for  re- 
placing an  old  worn-out  unit  with  a  new  one  ''out 
of  earnings"  will  be  approved.  The  decision  cer- 
tainly does  not  condemn  the  replacement  method. 
Nor  does  it  endorse  the  waterworks  plan  of  depre- 
ciation accounting  by  means  of  an  annual  allow- 
ance for  replacement.  It  specifically  mentions 
neither.  It  is  the  company's  "plain  duty"  to  "make 
provision  for  its  (the property's)  replacement."  In- 
asmuch as  both  methods  are  proper  for  certain 
classes  of  property  it  would  seem  to  be  clear  that 
the  company  might  choose  the  proper  one  to  fit  its 
conditions. 

{d)  Failure  to  provide  for  depreciation  or  re- 
placement will  close  the  door  to  consideration  of  any 
value  that  has  disappeared.  The  true  value — after 
the  deduction  of  depreciation — cannot  be  enhanced 
by  a  consideration  of  errors  of  the  management  in 
failing  to  provide  for  replacement. 

(e)  The  property  is  looked  upon  in  this  case  as 


168    DEPRECIATION  OF   PUBLIC    UTILITIES 

one  property,  a  composite  whole,  made  up  of  many 
different  parts.  "It  is  not  easy  to  fix  .  .  .  the 
amount  of  depreciation  of  a  plant  whose  compo- 
nent parts  are  of  different  ages,  with  different  ex- 
pectations of  life."  "To  arrive  at  the  present 
value  of  the  plant  large  deductions  were  made." 
From  this  point  on  the  references  to  "the  plant," 
"parts  of  the  plant,"  seem  to  leave  no  doubt  that  the 
court  considered  the  property  as  one  instrument  of 
service. 

(/)  Li  the  determination  of  depreciation  of  any 
property,  all  of  the  causes  of  depreciation  of  any  of 
the  parts  must  be  taken  into  account.  "But  that 
would  lead  to  incorrect  results  if  not  diminished  by 
the  depreciation  which  has  come  from  age  and  use." 
"The  complete  depreciation  represented  that  part 
,  .  .  which  through  destruction  or  obsolescence  had 
actually  perished." 

There  is  only  this  one  reference  to  obsolescence 
in  this  opinion,  and  nothing  is  said  which  can  be 
construed  as  approving  a  deduction  from  the  value 
of  property  units  still  in  service,  on  account  of  obso- 
lescence. Obsolete  property  which  has  disappeared, 
or  ceased  to  perform  the  function  for  which  it  was 
originally  installed  is  "complete  depreciation." 

This  opinion  brings  out  strongly  the  obligation 
resting  on  the  public  service  company  to  maintain 
its  property.  It  makes  more  clear  than  the  earlier 
cases  quoted,  the  obligation  resting  on  the  users  of 
the  utility  to  pay  for  maintenance,  including  depre- 
ciation. It  clearly  distinguishes  between  the  sums 
to  be  provided  for  current  repairs,  and  for  deprecia- 


APPENDIX  169 

tion  or  replacement,  and  it  clearly  recognizes  ''re- 
placement of  property"  as  making  good  deprecia- 
tion. 

Another  important  case  bearing  on  depreciation 
was  decided  six  weeks  after  the  Knoxville  case. 

Louisiana  Railroad  Commission  vs  Cumberland 
Telephone  and  Telegraph  Company,  212  U.  S.  p.  414. 
Decided  Feb.  23,  1909.    Justice  Peckham,  p.  423 ; 

"There  are  one  or  two  facts,  however,  now  to  be  taken  into 
consideration  before  the  correctness  of  that  conchision  can  be 
affirmed.  In  the  course  of  the  trial  various  questions  were  argued 
as  to  the  manner  of  conducting  such  a  business  as  this  with  regard 
to  extensions,  earnings,  and  disbursements,  as  well  as  questions  of 
depreciation  of  plant  and  how  to  treat  the  amount  collected  there- 
for, and  other  questions  of  that  nature.  Exactly  how  the  money 
which  resulted  from  the  rates  in  actual  operation  was  used  was 
not  in  all  cases  shown  in  detail,  either  from  the  books  or  by  oral 
testimony.  Something  was  left  in  doubt  and  to  conjecture.  In 
the  course  of  the  opinion  of  the  Circuit  Court  the  following  was 
said:  .  .  .  'Counsel  for  the  Commission  argued  that  the  com- 
plainant's property  in  Louisiana  was  not  all  paid  for  with  com- 
plainant's capital,  but  was  partly  paid  for  out  of  a  surplus  or 
reserve,  or  depreciation  fund,  which  was  accumulated  by  com- 
plainant from  the  receipts  of  its  Louisiana  business,  and  was 
then  reinvested,  not  in  repairs  and  maintenance,  but  in  extensions 
and  additions  to  the  property.  This  may  be  a  fact,  but  it  is  not 
shown  to  be  a  fact.'  .  .  . 

"If  the  onus  rested  upon  the  Commission  to  show  these  facts 
it  is  evident  that  the  obligation  has  not  been  fulfilled,  but  it  is 
just  here  that  the  difficulty  lies.  It  was  obligatory  upon  the 
complainant  to  show  that  no  part  of  the  money  raised  to  pay  for 
depreciation  was  added  to  capital,  upon  which  a  return  was  to  he 
made  to  stockholders  in  the  ivay  of  dividends  for  the  future.  It 
cannot  be  left  to  conjecture,  but  the  burden  rests  with  the  com- 
plainant to  show  it.  It  certainly  was  not  proper  for  the  com- 
plainant to  take  the  money,  or  any  portion  of  it,  which  it  received 


170    DEPRECIATION   OF   PUBLIC   UTILITIES 

as  a  result  of  the  rates  under  which  it  was  operating,  and  so  to 
use  it,  or  any  part  of  it,  as  to  permit  the  company  to  add  to  its 
capital  account,  upon  which  it  was  paying  dividends  to  share- 
holders. If  that  were  allowable,  it  would  be  collecting  money  to 
pay  for  depreciation  of  the  property,  and,  having  collected  it, 
to  use  it  in  another  way,  upon  which  the  complainant  would 
obtain  a  return  and  distribute  it  to  its  stockholders.  That  it  was 
right  to  raise  more  money  to  pay  for  depreciation  than  was 
actually  disbursed  for  the  particular  year  there  can  be  no  doubt, 
for  a  reserve  is  necessary  in  any  business  of  this  kind,  and  so 
it  might  accumulate,  but  to  raise  more  than  enough  money  for 
the  purpose  and  place  the  balance  to  the  credit  of  capital  upon 
which  to  pay  dividends  cannot  be  proper  treatment.  The  court 
below  said  that  it  was  impossible  to  find  out  from  the  books  how 
much  of  this  had  been  done,  and  it  treated  the  fact  as  one  to  be 
explained  by  the  commission  and  not  by  the  complainant.  We 
think,  on  the  contrary,  that  the  obligation  was  upon  the  com- 
plainant. Now,  although  the  books,  it  is  said,  do  not  show  how 
much  money  collected  for  depreciation  has  been,  in  fact,  used  to 
increase  the  capital  of  the  complainant  upon  which  dividends 
were  paid  to  stockholders,  yet  still,  even  if  the  books  do  not  show 
accurately,  or  even  at  all,  what  disposition  was  made  of  these 
moneys,  at  any  rate  the  officers  of  the  complainant  must  be  able 
to  make  up  some  reasonable  approximation  of  the  amount,  even 
if  it  be  impossible  to  state  it  with  entire  accuracy,  and  this  duty 
rests  with  the  complainant,  in  order  that  it  may  discharge  the 
duty  devolving  upon  it  to  prove  that  the  rates  were  not  unreason- 
ably high  under  Order  No.  488,  or  in  other  words,  that  they  were 
unreasonably  low  under  Order  No.  552.  It  may  be  that  the  sum, 
if  any,  thus  used  was  not  enough  to  affect  the  claim  that  the  rates 
under  discussion  were  unreasonably  low.  The  evidence  is  insuf- 
ficient to  show  clearly  that  which  complainant  is  under  obligations 
to  show.  Knoxville  vs  Water  Company,  212  U.  S.  1,  Willcox 
vs  Consolidated  Gas  Company  of  New  York,  212  U.  S.  19.  We 
are  not  considering  the  case  where  there  are  surplus  earnings 
after  providing  for  a  depreciation  fund,  and  the  surplus  is 
invested  in  extensions  and  additions.  We  can  deal  with  such  a 
case  when  it  arises." 


APPENDIX  171 

And  again  on  p.  427,  the  court  says : 

"But  the  burden,  as  we  have  said,  rests  with  the  complainant 
to  prove  its  case,  and  it  has  not  performed  its  obligation  when 
this  fact  as  to  the  disposition  of  the  so-called  depreciation  fund 
is  left  so  wholly  in  doubt.  What  is  the  amount  reserved  for 
payments  for  depreciation?  What,  if  any  of  it,  has  been  car- 
ried into  capital?  How  much  of  the  floating  debt  would  carry 
interest  which  might  be  charged  as  against  the  amount  of  the 
depreciation  fund  actually  used  for  extensions  and  additions  and 
charged  to  capital?  All  these  are  questions  not  answered  by  the 
evidence  in  the  case,  and  which  should  be  made  as  clear  as  pos- 
sible before  an  attempt  ought  to  be  made  to  answer  the  question 
as  to  rates.  The  whole  case  sTiould,  therefore,  be  opened,  so  that 
both  sides  can,  on  a  new  trial,  bring  out  all  the  material  facts 
upon  which  a  decision  can  finally  be  based.  We,  therefore,  reverse 
the  decree  and  direct  a  new  trial."     (Italics  ours.) 

This  case  hinges  on  the  disposition  of  the  so-called 
depreciation  fund.  The  decision  recognizes  the  ne- 
cessity of  a  reserve  and  approves  the  raising  of 
''more  money  to  pay  for  depreciation  than  was  ac- 
tually disbursed  for  the  particular  year,"  but  it  also 
holds  that  it  is  improper  to  raise  more  money  than 
is  needed  for  that  purpose  and  to  place  the  balance 
to  the  credit  of  capital. 

In  effect  it  would  seem  that  the  court  held  that  it 
is  not  a  depreciation  fund  to  be  returned  to  the 
owners  to  compensate  them  for  the  loss  of  value 
sustained  through  depreciation,  or  in  other  words 
to  amortize  the  investment,  but  rather  a  maintenance 
fund  to  be  held  in  trust  and  to  be  used  to  main- 
tain the  property  always  in  a  condition  of  complete 
efficiency.  This  decision  may  be  taken  as  a  warning 
from  the  Supreme  Court  that  accounting  must  be 


172    DEPRECIATION  OF  PUBLIC  UTILITIES 

done  properly.  It  is  perfectly  obvious  that  if  ex- 
cessive amounts  are  raised  for  a  depreciation  re- 
serve the  net  earnings  are  understated.  In  view  of 
all  that  has  been  said  by  the  Supreme  Court  in  prior 
and  subsequent  cases  recognizing  that  it  is  the  prop- 
erty itself,  and  not  the  cost  of  it,  that  is  protected 
by  the  constitutional  guarantee,  it  is  not  to  be 
assumed  from  this  language  that  the  court  ever 
intended  to  exclude  property  paid  for  out  of  ex- 
cessive accumulations  for  depreciation,  but  rather 
to  insist  that  reserves  so  created  shall  not  be  ex- 
cessive, and  that  the  accounting  shall  clearly  show 
the  disposition  of  these  reserves. 

A  Kentucky  Federal  case  is  of  interest  in  that  it 
discusses  the  subject  of  a  proper  allowance  to  off- 
set future  depreciation,  and  again  lays  stress  on 
the  duty  of  always  maintaining  the  property  up  to 
proper  standard. 

Cumberland  Telephone  and  Telegraph  Company 
vs  City  of  Louisville,  187  Fed.  637.  Decided  Apri] 
25,  1911.  U.  S.  Circuit  Court  W.  D.  Kentucky.  Dis- 
trict Judge  Evans,  p.  653 : 

"A  very  intelligent  witness — George  Wilkinson — in  his  deposi- 
tion said:  'Depreciation  may  be  defined  as  the  loss  in  value  of 
some  destructible  property  over  and  above  current  repairs.' 

"We  accept  this  as  a  sufficiently  accurate  definition  of  that  form 
of  depreciation  which  now  concerns  us.  What  sum  should,  year 
by  year,  be  set  ajoart  to  resupply  values  lost  in  the  current  de- 
preciation of  what  may  be  called  the  company's  working  plant  is 
not  always  a  matter  of  easy  solution.  ...  In  estimating  depre- 
ciation we  shall,  therefore,  reckon  it  at  7  per  cent  on  $1,575,000, 
which  we  have  found  to  be  the  value  of  the  destructible  parts  of 
the  plant.    In  reaching  this  conclusion  we  have  borne  in  mind  that 


APPENDIX  173 

the  past  is  fixed.  We  cannot  change  it.  But  taking  the  com- 
pany's plant  as  it  now  is  and  as  it  probably  will  become  in  the 
future,  and  remembering  that  the  value  of  its  real  estate  and 
working  capital  will  almost  certainly  not  depreciate  at  all,  the 
problem  has  been  to  ascertain  what  per  centum  of  the  earnings  of 
the  company  will  be  required  to  keep  what  is  called  its  plant 
always  in  as  good  condition  as  it  is  now  or  as  it  may  become. 
Of  course  our  estimate  could  not  be  based  upon  the  proposition 
that  the  per  centum  set  apart  to  cover  depreciation  would  be  de- 
posited in  bank  and  loaned  out  from  year  to  year  so  as  to 
accumulate  and  be  on  hand  at  the  end  of  fourteen  years,  and  to 
be  then  used  to  construct  an  entirely  new  plant,  and  so  on  from 
period  to  period.  In  such  a  case  the  public  would  not  only  have 
a  service  that  would  grow  progressively  worse  until  its  operations 
ceased  altogether,  hut  it  would  thereafter  get  no  service  at  all 
until  a  new  plant  replacing  the  old  could  he  completed  and  put 
into  operation.  The  question  rather  has  been,  what  does  experi- 
ence show  to  he  the  proper  average  per  cent  of  annual  earnings 
which  the  company  should  expend  in  order  to  insure  that  its  plant 
at  the  end  of  fourteen  years  will  be  as  good  as  it  now  is,  and  in 
the  meantime  render  to  the  public  that  good  service  which  its 
duty  to  the  public  requires.  The  master,  after  finding  that  the 
cost  of  the  plant  was  $1,506,531.21,  finds  that  its  present  value 
is  only  $1,355,878.09.  If  this  is  correct  it  certainly  indicates  that 
in  the  i^ast  enough  money  has  not,  from  time  to  time,  been  ex- 
pended upon  the  reconstruction  and  reinstatement  to  make  good 
the  depreciation  and  keep  the  ever-failing  parts  of  the  plant  up 
to  the  standard  by  resupplying  all  values  that  have  been  de- 
stroyed. And  if  this  is  true,  the  company's  inadequate  expendi- 
tures in  the  past  do  not,  per  se,  furnish  a  safe  guide  for  the 
ascertainment  of  what  should,  in  the  future,  be  set  aside  for 
depreciation.  .  .  . 

"It  may  not  be  out  of  jDlace  in  this  connection  to  observe  that 
in  private  business  where  the  owner  may  fix  his  own  prices  for  the 
use  of  the  property  his  own  honesty  may  compel  him  to  keep  the 
property  he  hires  to  others  up  to  a  standard  that  will  induce  them 
to  use  it,  but  no  one  can  directly  compel  him  to  do  so.  It  is 
different  with  public  utility  corporations.     The  owners  in  such 


174    DEPRECIATION  OF  PUBLIC  UTILITIES 

eases  have  not  the  absolute  and  uncontrolled  right  to  fix  their 
own  prices  for  the  use  of  the  public  of  the  utilities  they  furnish. 
Understand,  prices  may,  within  certain  limits,  be  regulated  by 
public  authority,  but  when  authority  attempts  to  regulate  the 
rates  to  be  charged  for  the  use  of  the  property  of  another,  it 
must  take  into  consideration  and  allow  what  would  be  a  fair 
amount  of  the  earnings  of  the  property  to  be  devoted  to  keeping 
it  always  up  to  the  public  standard.  What  interest  may  force  the 
private  owner  to  do  in  respect  to  his  own  property  the  law  com- 
pels public  authority  to  do  when  the  latter  undertakes  to  fix  rates 
to  be  charged  by  public  utilities  corporations."     (Italics  ours.) 

This  decision  clearly  recognizes  the  obligation  to 
maintain  the  plant  in  a  normal  operating  condition 
and  the  necessity  of  providing  money  ^vith  which  to 
keep  up  to  this  standard. 

Lincoln  Gas  and  Electric  Light  Company  vs  City 
of  Lincoln,  223  U.  S.  p.  349.  Decided  Feb.  19,  1912. 
Justice  Lurton.    Syllabus: 

"What  sum  should  be  annually  deducted  from  gross  or  net 
receipts  of  a  public  service  corporation  for  depreciation  and  re- 
placement and  how  it  should  be  applied,  are  novel  and  grave 
problems',  and,  in  the  absence  of  a  full  report  as  to  every  element 
involved,  this  court  is  not  justified  in  passing  upon  them." 

On  p.  363  the  court  says : 

"The  question  as  to  what  sum,  if  any,  upon  the  facts  of  this 
case  should  be  annually  deducted  from  the  net  income  as  a  per- 
manent maintenance  or  replacement  fund,  is  novel  and  presents 
a  grave  problem. 

"Conflicting  expert  evidence  has  been  introduced  presenting 
radically  different  theories  as  to  the  necessity,  character  and 
amount  of  such  a  fund,  and  as  to  how  it  should  be  created,  pre- 
served and  expended.  Some  of  this  evidence  puts  the  sum  to 
be  annually  deducted  and  set  aside  as  a  permanent  fund  at  five 


APPENDIX  175 

per  cent  upon  the  value  of  the  plant  at  the  time  of  deduction. 
It  is  obvious  that  if  this  view  is  sound  there  will  be  little  or 
nothing  of  the  net  income  left  for  distribution  among  share- 
holders, and  no  basis  for  legislative  rate  reduction  now,  and  none 
likely  until  such  time  as  the  income  from  the  permanent  fund  will 
keep  up  the  plant.  The  work  of  reconstructing  and  replacing  old 
parts  by  new  in  a  plant  of  this  kind  must,  in  the  very  nature  of 
things,  be  going  on  constantly.  Heretofore  it  seems  to  have  been 
so  well  and  continuously  done  that  the  value  of  the  plant  as  a 
whole  has  suffered  less  than  one  per  cent  per  annum  if  the  total 
depreciation  be  distributed  through  the  more  than  thirty  years  of 
operation.  So  far  as  can  be  now  seen,  reconstruction  and  replace- 
ment charges  have,  up  to  the  present  time,  been  borne  by  current 
revenue,  with  the  result  that  the  revenue  remaining  in  the  single 
year  of  1907  showed  a  net  surplus  of  $73,851.83,  a  sum  large 
enough,  if  distributed  to  shareholders  upon  the  basis  of  the  value 
of  property  engaged  in  the  business  as  claimed  by  appellant,  to 
have  paid  a  dividend  of  ten  per  cent  and  about  fifteen  per  cent 
upon  the  valuation  settled  by  the  Circuit  Court. 

"There  is  no  finding  as  to  the  extent  of  the  application  of  the 
revenue  of  1907  to  reconstruction  or  replacement,  as  distinguished 
from  current  repairs  and  operating  expenses.  It  is,  however, 
plainly  inferable  that  the  revenue  of  that  year  was  used  to  the 
extent  necessary.  If,  in  the  past,  reconstruction  and  replacement 
charges  have  been  met  out  of  current  expenses,  the  fact  must  be 
taken  into  consideration,  both  when  we  come  to  estimating  future 
net  income  and  in  determining  what  sum  shall  be  annually  set 
aside  to  guard  against  future  depreciation.  This  doubtless  in- 
fluenced the  court  below  in  settling  upon  the  amount  of  $8,000  as 
a  sufficient  annual  appropriation  of  income  as  insurance  against 
future  depreciation.  But  if  the  constantly  recurring  necessity 
to  do  reconstruction  or  re^jlacement  xoork  was  in  1907  met  out 
of  the  current  income  of  that  year,  thereby  diminishing  the  net 
income,  the  fact  should  be  given  weight  in  estimating  future  net 
income;  otherwise  there  will  be  a  double  deduction  on  that 
account,  first,  by  paying  such  charges  as  they  occur,  and  there- 
after by  a  contribution  out  of  the  remaining  income  for  the  same 
object. 


176    DEPRECIATION   OF   PUBLIC   UTILITIES 

"The  facts  found  are  not  full  enough  to  at  all  justify  this  court 
in  dealing  with  this  problem  of  a  replacement  fund. 

"There  should  he  a  full  report  upon  past  depreciation,  past 
expense  for  reconstruction  and  replacement,  and  past  operating 
expenses,  including  current  repairs.  We  should  be  advised  as  to 
the  gross  receipts  for  recent  years,  and  just  how  these  receipts 
have  been  exj^ended.  Then  the  amount  to  he  set  aside  for  future 
depreciation  will  depend  upon  the  character  and  probable  life  of 
the  property  and  the  method  adopted  in  the  past  to  preserve  the 
property.  It  can  be  readily  seen  that  the  amount  to  be  annually 
set  aside  may  be  such  as  to  forbid  rate  reductions  because  of  the 
requirement  of  such  a  fund.  The  matter  is  one  for  a  skilled 
master,  who  should  make  a  full  report  upon  the  value  of  the 
property,  the  receipts  and  the  expense  of  operation  and  the  sums 
paid  out  on  reconstruction  and  replacements,  and  in  dividends 
in  recent  years."     (Italics  ours.) 

It  is  noted  that  in  this  case  Justice  Lurton  speaks 
of  the  fund  as  a  "maintenance  or  replacement 
fund,"  and  as  a  "replacement  fund,"  by  inference 
placing  the  same  construction  as  is  to  be  drawn  from 
Justice  Peckham's  Telephone  decision,  namely  that 
the  fund  is  not  in  a  strict  sense  a  depreciation  fund 
to  be  paid  to  the  owner,  but  rather  a  fund  to  be  held 
in  trust  for  renewal  of  the  property  for  which  it 
was  created. 

This  case  recognizes  maintenance  of  the  integrity 
of  the  property  through  replacement.  "If  in  the 
past  reconstruction  and  replacement  charges  have 
been  met  out  of  current  expenses,  the  fact  must  be 
taken  into  consideration."  Attention  is  directed 
to  the  fact  that  the  replacing  of  old  parts  by  new 
has  been  so  well  done  that  the  value  of  the  2??awi 
as  a  ivhole  had  suffered  less  than  one  per  cent  per 
annum. 


APPENDIX  177 

Stress  is  also  laid  on  ^'the  character  and  probable 
life  of  the  property  and  tlie  method  adopted  in  the 
past  to  preserve  the  property"  as  being  important 
points  for  consideration. 

There  is  also  a  clean-cut  recognition  of  two 
methods  of  providing  for  replacement  otherwise 
there  will  be  a  double  deduction  on  that  account, 
first,  by  paying  such  charges  as  they  occur  (the  re- 
placement method)  and  thereafter  by  a  contribution 
out  of  the  remaining  income  for  the  same  object. 
(The  method  of  reserves  for  replacement,  or  so- 
called  depreciation  accounting.) 

This  case,  like  the  Cumberland  Telephone  case, 
raises  questions  as  to  methods  of  accounting  and 
warns  against  excessive  depreciation  deductions.  It 
is  obvious  that  the  creation  of  reserves,  in  excess 
of  the  real  need  of  the  property,  and  the  resulting 
understatement  of  actual  net  earnings  is  contrary 
to  the  spirit  of  this  opinion. 

The  Minnesota  Rate  cases,  230  U.  S.  p.  352.  De- 
cided June  9,  1913.  Justice  Hughes  says  in  the 
Opinion  on  pp.  456  and  457 : 

"The  property  other  than  land,  as  the  detailed  statement  shows, 
embraced  all  items  of  construction,  including  roadbed,  bridges, 
tunnels,  etc.,  structures  of  every  sort,  and  all  appliances  and 
equipment.  The  cost  of  reproduction  new  was  ascertained  by 
reference  to  the  prices  for  such  work  and  property.  In  view  of 
Ae  range  of  the  questions  we  have  been  called  upon  to  consider, 
we  shall  not  extend  this  opinion  for  the  purpose  of  reviewing  this 
estimate,  or  of  passing  upon  exceptions  to  various  items  in  it,  as 
their  disposition  would  not  affect  the  results. 

"The  Master  allowed  the  cost  of  reproduction  new  without 
deduction  for  depreciation.     It  was  not  denied  that  there  was 


178    DEPRECIATION   OF   PUBLIC   UTILITIES 

depreciation  in  fact.  As  the  Master  said,  'Everything  on  and 
above  the  road-bed  depreciates  from  wear  and  weather  stress. 
The  life  of  a  tie  is  from  eight  to  ten  years  only.  Structures  be- 
come antiquated,  inadequate  and  more  or  less  dilapidated.  Bal- 
last requires  renewal,  tools  and  machinery  wear  out,  cars,  loco- 
motives and  equipment,  as  time  goes  on  are  worn  out  or  discarded 
for  newer  types.'  But  it  was  found  that  this  depreciation  was 
more  than  offset  by  appreciation;  that  'the  road-bed  was  con- 
stantly increasing  in  value';  that  it  'becomes  solidified,  embank- 
ments and  slopes  or  excavations  become  settled  and  stable  and 
so  the  better  resist  the  effects  of  rains  and  frost' ;  that  it  'becomes 
adjusted  to  surface  drainage,  and  the  adjustment  is  made  per- 
manent by  concrete  structures  and  rip-rap';  and  that  in  other 
ways,  a  road-bed  long  in  use  'is  far  more  valuable  than  one  newly 
constructed.'  It  was  said  that  'a  large  part  of  the  depreciation  is 
taken  care  of  by  constant  repairs,  renewals,  additions  and  re- 
placements, a  sufficient  sum  being  annually  set  aside  and  devoted 
to  this  purpose,  so  that  this,  with  the  application  of  road-bed 
and  adaptation  to  the  needs  of  the  country  and  of  the  public 
served,  together  with  working  capital  .  .  .  fully  offsets  all  de- 
preciation and  renders  the  physical  properties  of  the  road  not 
less  valuable  than  their  cost  of  reproduction  new.'  And  in  a 
further  statement  upon  the  point,  the  'knowledge  derived  from 
experience'  and  'readiness  to  serve'  were  mentioned  as  additional 
offsets. 

"We  cannot  approve  this  disposition  of  the  matter  of  deprecia- 
tion. It  appears  that  the  Master  allowed,  in  the  cost  of  repro- 
duction, the  sum  of  $1,613,612  for  adaptation  and  solidification 
of  road-bed,  this  being  included  in  the  item  of  grading  and  being 
the  estimate  of  the  engineer  of  the  state  commission  of  the  proper 
amount  to  be  allowed.  It  is  also  to  be  noted  that  the  depreciation 
in  question  is  not  that  which  has  been  overcome  by  repairs  and 
replacements,  but  is  the  actual  existing  depreciation  in  the  plant 
as  compared  with  the  new  one.  It  would  seem  to  be  inevitable 
that  in  many  parts  of  the  plant  there  should  be  such  depreciation, 
as  for  example  in  old  structures  and  equipment  remaining  on 
band.  And  when  an  estimate  of  value  is  made  on  the  basis  of 
reproduction  new,  the  extent  of  existing  depreciation  should  be 


APPENDIX  179 

shown  and  deducted.  This  apparently  was  done  in  the  statement 
admitted  by  this  company  to  the  Interstate  Commerce  Commission 
in  the  Spokane  Rate  case  in  connection  with  an  estimate  of  the 
cost  of  reproduction  of  the  entire  system  as  of  March,  1907.  (See 
15  I.  C.  C.  Rep.  395,  396.)  In  the  present  case,  it  appears  that 
the  engineer  of  the  state  commission  estimated  the  depreciation 
in  the  property  as  between  eight  and  nine  million  dollars.  If 
there  are  items  entering  into  the  estimate  of  cost  which  should 
be  credited  with  appreciation,  this  also  should  appear,  so  that 
instead  of  a  broad  comparison  there  should  be  specific  findings 
showing  the  items  which  enter  into  the  account  of  physical  valua- 
tion on  both  sides. 

"It  must  be  remembered  that  we  are  concerned  with  a  charge 
of  confiscation  of  property  by  the  denial  of  a  fair  return  for  its 
use;  and  to  determine  the  truth  of  the  charge  there  is  sought  to 
be  ascertained  the  present  value  of  the  property.  The  realization 
of  the  benefits  of  property  must  always  depend  in  large  degree 
on  the  ability  and  sagacity  of  those  who  employ  it,  but  the  ap- 
praisement is  of  an  instrument  of  public  service,  as  property,  not 
of  the  skill  of  the  users.  And  when  particular  physical  items  are 
estimated  as  worth  so  much  new,  if  in  fact  they  are  depreciated, 
this  amount  should  be  found  and  allowed  for.  If  this  is  not  done, 
the  physical  valuation  is  manifestly  incomplete.  And  it  must  be 
regarded  as  incomplete  in  this  case.  Knoxville  vs  Knoxville 
Water  Company,  212  U.  S.  1-10."     (Italics  ours.) 

In  this  case  the  court  recognizes  the  points  noted 
in  the  Knoxville  case  as  follows:  (a)  The  Deprecia- 
tion noted  is  loss  of  value,  ''the  depreciation  is  not 
that  which  has  been  overcome  by  repairs  and  re- 
placements." (b)  Depreciation  which  has  actually 
taken  place  must  "be  found  and  allowed  for,"  it 
must  be  "shown  and  deducted."  (c)  The  property 
is  treated  as  one  composite  whole.  "The  appraise- 
ment is  of  an  instrument  of  public  service,  as  prop- 
erty .  .  .  and  when  particular  physical  items  are 


180    DEPRECIATION   OF  PUBLIC  UTILITIES 

estimated,  etc."  ''In  many  parts  of  the  plant  there 
should  be  such  depreciation,  as  for  example  in  old 
structures  and  equipment  remaining  on  hand." 
Throughout  the  reference  is  to  "  the  plant ' '  and  ' '  the 
property."  (d)  Age,  wear,  and  apparently  obso- 
lescence, are  all  recognized  as  causes  of  depreciation. 
''Structures  become  antiquated,  inadequate  and 
more  or  less  dilapidated,"  "are  worn  out  or  dis- 
carded for  newer  tj^Des."  These  expressions  leave 
little  room  for  doubt.  In  addition  this  case  settles 
the  question  that  there  must  be  specific  findings  of 
depreciation  and  not  a  broad  offsetting  of  appre- 
ciation against  depreciation. 

The  Minnesota  Eate  case  also  unequivocally  rec- 
ognizes the  propriety  of  keeping  the  investment  in- 
tact and  overcoming  depreciation  by  the  replace- 
ment of  parts  of  the  property.  The  views  of  the 
court  in  this  respect  are  indicated  by  the  reference 
to  a  statement  in  the  findings  of  the  Master  that 
"a  large  part  of  the  depreciation  is  taken  care  of 
by  constant  repairs,  renewals,  additions  and  replace- 
ments," and  the  court's  own  subsequent  statement 
"that  the  depreciation  in  question  is  not  that  which 
has  been  overcome  by  repairs  and  replacements, 
but  is  the  actual  existing  depreciation  in  the  plant 
as  compared  mth  a  new  one,"  There  is  nothing  in 
the  Minnesota  Rate  cases  bearing  on  the  use  of  the 
reserve  or  allowance  method  of  accounting. 

While  the  court  does  use  the  term  "actual  exist- 
ing depreciation  in  the  plant  as  compared  with  a 
new  one"  in  referring  to  the  necessity  for  deducting 
depreciation  in  making  an  estimate  on  the  basis  of 


APPENDIX  181 

reproduction  new,  it  is  not  to  be  inferred  that  a 
purely  conjectural  or  hypothetical  figure  is  to  be 
approved.  The  case  is  too  clear  on  that  point,  in 
sections  of  it  referring  to  land  valuation,  to  leave 
any  room  for  doubt  as  to  what  is  meant  by  the  clause 
just  referred  to.  Actual  loss  of  value,  computed  by 
a  rational  method,  and  capable  of  proof,  is  to  be 
deducted  from  the  fair  value  of  the  plant  as  a  whole. 

The  next  case  in  chronological  order  after  the 
Minnesota  Rate  cases  was  the  Kansas  City  South- 
ern Railway  case  decided  six  months  later  by  Justice 
Pitney.  In  view  of  the  importance  of  this  case 
from  an  accounting  standpoint,  and  on  account  of 
the  light  it  throws  on  the  court's  own  interpretation 
of  depreciation  principles  stated  in  the  Knoxville 
Case,  the  decision  is  quoted  at  considerable  length. 

Kansas  City  Southern  Railway  vs  United  States, 
231  U.  S.  p.  423.  Decided  Dec.  1,  1913.  Justice 
Pitney  gave  the  decision.  On  p.  444  he  refers  to 
capital  accounts  and  operating  accounts  as  follows: 

"We  are  thus  brought  back  to  the  fundamental  distinction 
between  (a)  the  property  or  capital  accounts,  designed  to  repre- 
sent the  investment  of  the  stockholders,  and  to  show  the  cost  of 
the  property  as  originally  acquired,  with  subsequent  additions 
and  improvements;  these  assets  being  balanced  by  the  liabilities, 
including'  the  amount  of  the  capital  stock  and  all  bonded  and  otlier 
indebtedness,  with  net  profits  or  surplus,  whether  carried  under 
the  head  of  "profit  and  loss"  or  otherwise;  and  (6)  the  operating 
accounts,  designed  to  show,  on  the  one  side,  gross  receipts  or  gross 
earnings  for  the  year,  and  on  the  other  side,  the  expenditures 
involved  in  producing  those  gross  earnings  and  in  maintaining 
the  property,  the  balance  being  the  net  earnings." 


182    DEPRECIATION  OF  PUBLIC  UTILITIES 

On  p.  447  Justice  Pitney  discusses  depreciation  in 
the  following  language : 

"The  contention  of  the  appellant  that  property,  originally 
acquired  because  necessary  in  the  construction  of  the  road,  and 
afterwards  abandoned  only  because  rendered  unnecessary  by  the 
improvement  and  development  of  the  property,  should  remain 
in  the  property  account  as  a  part  of  the  stockholders'  investment, 
will  be  found,  upon  analysis,  to  rest  upon  the  unwarrantable 
assumption  that  all  capital  expenditures  result  in  permanent 
accretions  to  the  property  of  the  company.  This  in  effect  ignores 
depreciation — an  inevitable  fact  which  no  system  of  accounts 
can  properly  ignore.  A  more  complete  depreciation  than  that 
which  is  represented  by  a  part  of  the  original  plant  that  through 
destruction  or  obsolescence  has  actually  perished  as  useful  prop- 
erty, it  would  be  difficult  to  imagine.  The  fact  that  the  original 
investment  was  necessary  in  order  that  the  second  investment 
might  be  made  is  not  a  conclusive  test.  Reference  is  made  to  the 
cost  of  the  scaffolding  used  in  the  erection  of  a  house,  and  dis- 
carded when  the  house  is  completed;  and  to  the  cost  of  the  paper 
that  goes  to  the  waste  basket,  rather  than  to  the  printer,  in  the 
preparation  of  a  literary  composition;  but  these  are  fanciful 
analogies,  and  do  not  assist  us,  where  the  real  question  is  not  how 
shall  original  cost  be  ascertained,  but  how  shall  subsequent  de- 
preciation in  value  be  reckoned  and  accounted  for? 

"In  Knoxville  vs  Water  Company,  212  U.  S.  1,  this  court  had 
to  do  with  a  similar  element  of  depreciation,  and,  after  pointing 
out  that  such  a  plant  as  was  there  in  question  begins  to  depre- 
ciate in  value  from  the  moment  of  its  use,  and  that  before  coming 
to  the  question  of  profit  at  all,  the  company  was  entitled  to  earn 
a  sufficient  sum  annually  to  provide  not  only  for  current  repairs 
but  for  making  good  the  depreciation  and  replacing  the  parts  of 
the  property  when  they  should  come  to  the  end  of  their  life,  the 
court  proceeded  to  say,  (p.  14) :  'If,  however,  the  company  fails 
to  perform  this  plain  duty  and  to  exact  sufficient  returns  to  keep 
the  investment  unimpaired,  whether  this  is  the  result  of  unwar- 
ranted dividends  upon  over-issues  of  securities,  or  of  omission  to 
exact  proper  prices  for  the  output,  the  fault  is  its  own.  When, 


APPENDIX  183 

therefore,  a  public  regulation  of  its  prices  comes  under  question 
the  true  value  of  the  property  then  employed  for  the  purpose  of 
earning  a  return  cannot  be  enhanced  by  a  consideration  of  the 
errors  in  management  which  have  been  committed  in  the 
past.'  .  .  . 

"It  is  insisted  upon  that  if  the  appellant,  having  expended  in 
round  figures  $600,000,  secured  by  the  sale  of  bonds  for  improve- 
ments, can  be  compelled  to  charge  $400,000  of  that  amount  to 
the  operating  expense  of  one  year  or  to  distribute  it  among  the 
operating  expenses  of  a  series  of  years,  and  if  it  be  forbidden  to 
keep  any  other  record  representing  the  transaction,  it  will  have 
in  its  possession  no  kind  of  record  from  which  it  can  report 
accurately  either  the  cost  of  its  property  or  the  cost  of  improve- 
ments or  its  operating  expense.  This,  we  think,  is  a  misappre- 
hension of  the  effect  of  the  regulations.  They  do  not  require 
appellant  to  falsify  its  books  or  to  change  in  any  way  the 
evidential  character  of  the  original  entries.  The  source  of  the 
money  and  the  distribution  made  of  it  as  expended,  may  and 
should  be  correctly  shown.  The  regulations  do  require  that  the 
contemporaneous  abandormient  of  other  property  be  likewise 
shown,  and  the  replacement  cost,  less  salvage,  charged  to  the 
appropriate  accounts  under  operating  expense.  This,  if  observed, 
of  course,  results  in  enforcing  a  prescribed  distinction  between 
capital  expense  and  operating  expense.  It  does  not  require  that 
the  record  of  the  expenditure  be  obliterated ;  but  it  does  of  course 
affect  the  results  as  they  work  out  upon  the  balance  sheet.  If 
this  be  fairly  done,  there  is  no  transmutation  of  new  property  into 
operating  expenses,  hut  only  the  insistence  upon  the  requirement 
that  new  projjerty  added  shall  not  alone  he  the  measure  of  the 
accretion  to  the  property  account,  hut  that  the  depletion  attrihu- 
tahle  to  contemporaneous  abandonment  of  their  property  shall 
likewise  be  reflected  upon  the  hooks. 

"The  theory  upon  which  the  Commission  has  acted  in  formu- 
lating its  regulations  is  fairly  stated  in  its  brief  herein  as  follows : 
The  abandonment  of  property  incident  to  grade  revision  is  'de- 
preciation,' and  such  depreciation  is  of  two  kinds — (1)  that  which 
is  not  replaced  in  kind  and  (2)  that  which  is  replaced  by  im- 
proved materials,  track  or  equipment.     If  a  trunk  line  of  road 


184    DEPRECIATION  OF  PUBLIC   UTILITIES 

has  a  branch  extending  into  a  territory,  not  served  by  its  main 
line,  and,  finding  the  branch  unprofitable,  abandon  it,  taking  up 
the  track,  without  constructing  any  substitute  to  serve  the  same 
territory,  the  abandoned  branch  ceases  to  be  an  earning  instru- 
mentality; the  stockholders  can  thereafter  derive  no  i^rofit  from 
it;  it  has  served  its  purpose,  and  only  past  operations  have 
benefited  from  it.  So  far  as  the  profits  of  past  operations  have 
not  been  distributed  to  the  stockholders,  they  are  represented  in 
the  profit  and  loss  account,  and  therefore  such  an  abandonment 
or  depreciation  is  properly  chargeable  to  that  account  unless  a 
special  depreciation  account  has  been  established  in  anticipation 
of  such  abandonments;  and  for  such  an  account,  provision  is 
made  in  the  regulations.  The  other  kind  of  depreciation  is  the 
result  of  changes  attributable  to  the  inadequacy  of  the  existing 
property  to  meet  the  demands  of  the  future.  The  road  or  the 
structure  have  to  be  replaced  with  stronger  or  more  efficient  in- 
strumentalities. Abandonments  occasioned  by  changes  of  this 
character  are  therefore  chargeable  to  future  earnings,  for  the 
reason  that  the  imj^roved  condition  of  the  road  is  not  only  de- 
signed to  meet  the  demands  of  the  future,  but  presumably  will 
result  in  economies  of  operation,  and  so  the  resulting  benefits 
will  be  reaped  by  those  who  hold  stock  of  the  company  in  the 
present  and  in  the  future.  The  railroad  company  may,  if  it  sees 
fit,  anticipate  general  depreciations,  and  make  provision  for  them 
by  establishing  a  reserve  for  that  purpose;  but  if  no  such  pro- 
vision has  been  made  the  abandonments  should  be  taken  care 
of  by  charging  them  to  present  or  future  operating  expense.  In 
fact,  however,  the  amount  is  so  large  that  its  inclusion  in  a  car- 
rier's operating  expenses  for  a  single  year  would  unduly  burden 
the  operating  expense  account  for  that  year,  the  carrier  may,  if 
so  authorized  by  the  commission,  distribute  the  cost  throughout 
a  series  of  years. 

"It  is  further  insisted  that  even  the  theory  uj^on  which  the 
accounting  regulations  rest  does  not,  when  analyzed,  justify  a 
charge  of  abandoned  property  to  operating  expenses,  but  at  most 
a  charge  to  profit  and  loss.  The  suggestion  apparently  has  force; 
but,  upon  consideration,  we  are  unable  to  see  that  it  furnishes 
ground  for  judicial  interference  with  the  course  pursued  by  the 


APPENDIX  185 

commission.  Except  for  the  contention  (already  disposed  of) 
that  the  value  of  the  abandoned  parcels  should  be  permanently 
carried  in  the  property  account  as  part  of  the  cost  of  progress, 
it  is  and  must  be  conceded  that  sooner  or  later  it  must  be  charged 
against  the  oj^erating  revenue,  either  past  or  future,  if  the  in- 
tegrity of  the  property  accounts  is  to  be  maintained;  and  it 
becomes  a  question  of  policy  whether  it  should  be  charged  in 
solido  to  profit  and  loss  (an  account  presumptively  representative 
of  past  accumulations)  or  to  the  operating  accounts  of  the  present 
and  future.  If  abandoned  property  is  not  charged  off  in  one 
way  or  the  other  it  remains  as  a  pennanent  inflation  of  the  prop- 
erty accounts,  and  tends  to  produce,  directly  or  indirectly,  a 
declaration  of  dividends  out  of  capital.  If  it  be  charged  to  the 
surplus  account,  it  tends  to  prevent  the  declaration  of  dividends 
based  upon  a  suj^jDosed  accumulation  of  past  earnings.  If 
charged  to  operating  exjjenses  of  the  current  and  future  years,  it 
has  a  tendency  to  prevent  the  declaration  of  dividends  from  cur- 
rent earnings  until  the  amount  of  the  depreciation  shall  have  been 
made  up  out  of  the  earnings." 

This  decision  discusses  the  necessity  of  a  ■aniform 
system  of  accounts  under  a  system  of  government 
regulation.  The  fundamental  distinction  between 
capital  accounts  and  operating  accounts  as  brought 
out  may  be  stated  thus : 

(a)  All  capital  expenditures  do  not  result  in 
permanent  property.  Depreciation  must  be  reck- 
oned with  and  accounted  for. 

(b)  The  cost  of  progress  theory,  or  as  it  has  been 
termed  in  some  valuation  work  "the  cost  of  develop- 
ment of  the  art"  is  not  admissible  to  the  extent 
of  leaving  in  property  accounts  the  cost  of  works 
built  and  subsequently  abandoned  or  superseded  by 
more  modern  works. 

(c)  The  accounting  methods  prescribed  by  the 


186    DEPRECIATION   OF  PUBLIC   UTILITIES 

Interstate  Commerce  Commission  are  approved  in 
so  far  as  they  permit  the  cost  of  new  property  to 
be  added  to  capital,  and  require  that  the  original 
cost  of  property  abandoned,  less  salvage,  shall  be 
credited  to  capital  and  charged  to  operating  ex- 
penses. 

{d)  Obsolescence,  "the  inadequacy  of  the  existing 
property  to  meet  the  demands  of  the  future,"  is  a 
charge  on  future  earnings  because  the  improvement 
is  designed  to  meet  the  needs  of  the  future,  and  be- 
cause it  will  result  in  economies,  the  benefit  of  which 
will  be  reaped  by  present  and  future  owners. 

This  case  deals  clearly  with  depreciation  in  the 
sense  of  complete  loss  of  value,  and  does  not  touch 
upon  any  question  of  the  computation  of  theoretical 
depreciation  or  its  deduction.  The  depreciation 
that  is  here  treated  is  the  complete  passing  out  of 
useful  service  of  a  section  of  property,  and  its  re- 
placement by  a  new  section  in  a  new  location. 

Nothing  could  be  more  plain  than  the  recognition 
of  the  court  of  the  two  methods  of  accounting  for 
depreciation.  The  road  may  make  provision  for 
general  depreciations  ''by  establishing  for  that 
purpose,"  or  by  charging  to  operating  expenses. 

These  cases  are  believed  to  cover  not  only  all  of 
the  most  important  decisions  up  to  Jan.  1,  1914,  but 
also  those  earlier  ones  which  are  of  value  as  show- 
ing the  chronological  development  of  the  conception 
of  Depreciation. 

The  decisions  of  this  period,  1909  to  1914,  are  the 
important  and  controlling  authority  on  which  both 
engineers  and  accountants  must  base  their  work. 


APPENDIX  187 

THIRD  PERIOD 
1914  TO  1922.    The  Period  of  War  and  Fluctuating  Prices 

Shortly  after  the  beginning  of  the  World  War 
prices  of  material  and  labor  commenced  to  increase, 
and  the  result  was  that  the  utilities,  especially  those 
whose  rates  were  fixed  by  contract,  began  to  ask 
for  relief.  Prices  increased  rapidly  after  the  entry 
of  the  United  States  into  the  war  in  1917,  reaching 
the  peak  in  the  autumn  of  1920.  The  issues  of  '^fair 
value"  became  acute  and  the  two  conceptions  of 
value,  that  of  reproduction  at  current  prices  and  that 
of  investment  were  both  strongly  urged.  The  subject 
of  depreciation  seems  to  have  been  considered  of 
secondary  importance.  The  decisions  quoted  are  be- 
lieved to  be  the  ones  which  are  entitled  to  greatest 
weight. 

One  state  court  case  which  is  of  distinct  interest 
as  one  of  the  first,  if  not  the  first  court  case  in 
which  there  is  recognition  of  the  possibility  of  so 
maintaining  a  property  that  depreciation  is  made 
good  by  replacements,  is  Pioneer  Telephone  and 
Telegraph  Company  vs  State,  decided  by  the  Su- 
preme Court  of  Oklahoma,  Sept.  25,  1917.  Kane, 
Judge.    167  Pacific,  995 : 

"(3)  Another  ground  for  complaint  is  based  upon  the  claim 
that  the  Corporation  Commission  refused  to  allow  the  company 
a  sufficient  reserve  for  depreciation.  The  Commission  held  that 
inasmuch  as  the  evidence  showed  that  the  physical  plant  was  kepi 
up  to  a  high  degree  of  efficiency  by  replacements  paid  for  out 


188    DEPRECIATION  OF  PUBLIC  UTILITIES 

of  current  revenue,  and  that  any  deterioration  covered  by  obso- 
lescence would  not  affect  the  result  in  the  ease  at  bar,  there  was 
no  depreciation,  and  therefore  an  allowance  for  a  reserve  fund 
to  take  care  of  depreciation  was  not  necessary,  and  should  not  be 
allowed.  The  contention  of  the  company  on  this  point  is  that, 
notwithstanding  every  part  of  a  properly  constructed  and  well- 
equipped  telephone  system  may  be  maintained  in  good  condition 
from  year  to  year  out  of  the  maintenance  fund,  yet  the  time  in- 
evitably comes  with  every  building  and  unit  of  equipment  when 
it  can  no  longer  be  kept  serviceable  by  repairs  or  current  main- 
tenance, and  when  it  must  be  replaced  substantially  in  its  entirety. 
Therefore,  they  say,  since  the  total  life  expectancy  of  the  parts 
of  the  entire  plant  may  be  measured  in  years  on  something  sim- 
ilar to  a  mortality  table  basis,  unless  a  depreciation  fund  is  pro- 
vided for  from  year  to  year  out  of  earnings,  sufiQcient  to  replace 
the  plant  substantially  in  its  entirety  at  the  end  of  each  life 
expectancy  period,  the  dividends  paid  will  before  long  represent 
the  better  part  of  the  stockholders'  investment.  A  great  many 
authorities  and  opinions  of  experts  are  cited  by  counsel  for  the 
company  which  they  say  conclusively  show  the  economic  necessity 
for  the  principle  contended  for,  among  which  are  the  following: 
Pioneer  Tel.  &  Tel.  Co.  vs  Westenhaver,  29  Okl.  429,  118  Pac. 
354,  38  L.  R,  A.  (N.  S.  1209),  State  Journal  Printing  Co.  vs 
Madison  Gas  &  Elec.  Co.,  4  W.  R.  C.  501;  in  re  Application  of 
Cumberland  Municipal  Elec.  Lighting  Co.,  4  W.  R.  C.  214; 
Cunningham  et  al.  vs  Chippewa  Falls  Water  &  L.  Co.,  5  W.  R.  C. 
302;  Puget  Sound  Elec.  Ry.  Co.  vs  Railroad  Commission  of 
Washington,  65  Wash.  75,  117  Pac.  739,  Ann.  Cas.  1913B,  763; 
People  ex  rel.  Manhattan  Ry.  Co.  vs  Woodbury  et  al.,  203  N.  Y. 
231,  96  N.  E.  420 ;  People  ex  rel.  Third  Avenue  Ry.  Co.  vs  State 
Board  of  Tax  Commissioners,  136  App,  Div.  155,  120  N.  Y. 
Supp.  528. 

"The  expert  opinion  relied  upon  consists  of  an  article  by 
William  B.  Jackson,  entitled,  'Depreciation  and  Reserve  Funds 
of  Electrical  Properties,'  published  in  The  Electrical  Review  of 
May  7,  1910,  p.  934,  the  report  of  William  J.  Hagenah  in  his 
Investigation  of  the  Chicago  Telephone  Co.,  1910,  and  in  the 
second  volume  of  Telephony,  page  102.    After  examining  such  of 


APPENDIX  189 

these  authorities  as  are  available  to  us,  and  others'  on  the  same 
subject  not  cited,  we  find  ourselves  unable  to  agree  with  counsel 
in  their  assumption  that  the  doctrine  of  depreciation,  as  contended 
for  by  them,  meets  with  the  universal  approval  of  the  courts  and 
the  economists.  From  our  investigation  of  the  problem  of  depre- 
ciation we  are  convinced  that  precedent  on  this  question  is  vary- 
ing, and  that  there  is  also  great  contrariety  of  opinion  among  the 
heads  of  public  service  corporations  themselves,  some  companies 
believing  that  their  best  interests  lie  in  adopting  the  largest  pos- 
sible depreciation  charge  and  in  the  consequent  accumulation  of 
a  permanent  fund  in  the  future,  whilst  others  contend  that  the 
application  of  the  doctrine  amounts  to  a  virtual  confiscation  of 
their  property.  Without  attempting  to  set  out  herein  our  analysis 
of  these  discordant  views,  it  is  sufficient  to  say  that  we  have 
reached  the  conclusion  that  in  plants  of  considerable  size  that 
have  attained  their  gait,  to  which  class  the  plant  herein  is  con- 
ceded to  belong,  there  is  both  theoretically  and  actually  a  normal 
condition  in  which  the  replacements  come  along  with  comparative 
evenness,  and  where  there  can  be  no  possible  use  for  a  so-called 
depreciation  fund  of  any  considerable  amount. 

"In  the  case  at  bar,  as  we  have  seen,  the  Commission  made  no 
deduction  from  the  valvae  of  the  plant  on  account  of  depreciation, 
but  allowed  returns  upon  its  value  as  a  going  concern,  kept  up  to 
a  high  degree  of  efficiency  by  replacements  paid  for  out  of  cur- 
rent revenue.  There  is  no  principle  of  public  regulation  more 
firmly  established  than  the  right  of  the  company  to  charge  in  its 
rate  an  amount  which  will  enable  it  to  make  these  replacements, 
and  as  investors  put  their  money  into  public  utilities  for  the 
sake  of  the  returns  they  will  be  able  to  obtain,  if  the  allowance 
for  replacements  is  sufficient  to  keep  up  a  high  degree  of  efficiency 
and  prevent  a  lowering  of  the  ability  of  the  plant  to  earn  returns, 
we  are  unable  to  perceive  the  necessity  for  building  up  a  fund 
to  be  used  for  the  purpose  of  counteracting  a  purely  theoretical 
depreciation.  The  theory  of  the  Commission  seems  to  be  that 
charges  should  be  made  in  rates  sufficient  to  counteract  or  pre- 
vent depreciation  by  replacements,  and  that  when  replacements 
are  thus  fully  provided  for,  depreciation  is  counteracted.    We  see 


190    DEPRECIATION   OF   PUBLIC   UTILITIES 

no  error  in  this :    at  least,  none  of  which  the  appellant  company 
has  any  just  cause  to  complain."     (Italics  ours.) 

Consolidated  Gas  Compa^iy  of  Neiv  York  vs  New- 
ton, 267  Fed.  231,  District  Court,  S.  D.  N.  Y.  Aug. 
4,  1920,  Supplemental  opinion  Aug.  11,  1920. 
Learned  Hand,  Judge. 

This  opinion  has  been  referred  to  frequently  as 
in  it  Judge  Hand  took  a  most  pronounced  stand  in 
favor  of  prices  prevailing  at  the  time  of  inquiry. 
The  discussion  of  depreciation  in  this  opinion  is 
dstinctly  different  and  is  here  quoted  in  full: 

"Depreciation 

"(3)  The  defendants  insist  upon  the  element  of  depreciation, 
based  upon  an  allowance  each  year  of  that  proportion  of  the  total 
value  which  a  year  bears  to  the  whole  life  of  the  plant.  The 
Supreme  Court  (Knoxville  Water  Co.  vs  Knoxville,  supra; 
Minnesota  Rate  cases,  supra)  has  recognized  that  some  deprecia- 
tion is  a  proper  element  in  estimating  the  'rate  base,'  but  has  not 
as  yet  authoritatively  settled  on  what  principle  it  shall  be  cal- 
culated. It  seems  to  me  hardly  possible  in  the  case  at  bar  to 
avoid  taking  a  position  with  regard  to  that  principle. 

"If  the  proper  standard  for  a  'rate  base'  is  the  present  cost 
of  a  substitute  plant  of  equal  capacity,  as  I  believe,  depreciation 
can  be  a  function  of  it  only  in  case  the  allowance  for  renewals  to 
the  plant  under  consideration  will  in  the  future  be  greater  than 
that  of  the  assumed  standard.  If  the  rates  allowed  in  the  future 
include  only  an  allowance  for  renewals  of  a  new  plant,  the  com- 
pany will  have  to  abate  something  from  its  normal  profits  be- 
cause of  its  extraordinary  renewal  charges.  Theoretically  it 
makes  no  difference  whether  this  problem  is  met  by  giving  the 
plant  a  smaller  value  at  present  because  of  its  future  greater 
renewal  charges,  and  then  allowing  a  higher  rate  for  renewals, 
or  by  giving  it  its  present  value,  based  on  capacity,  and  letting 


APPENDIX  191 

it  bear  its  extra  renewals  out  of  its  normal  profits.  Were  the 
jDlant  sold,  the  future  abnormal  renewals  would  be  reflected  in  the 
sale  price,  being  discounted  at  once;  but  that  would  be  because 
the  parties  must  at  present  clear  their  accounts  once  and  for  all. 
The  seller  would  be  unwilling  at  once  to  abate  from  his  price,  and 
later  to  allow  the  buyer  from  time  to  time  for  his  unusual  re- 
newals. In  the  case  of  a  public  service  company,  where  the 
authorities  may  always  require  the  plant  to  be  kept  up  to 
standard,  there  is  an  obvious  advantage  in  declining  to  attempt 
a  repeated  adjustment  between  the  actual  renewals  necessary  and 
normal  renewals,  as  would  be  necessary  if  the  present  prospect 
of  such  allowances  were  now  discounted;  it  is  the  better  practice 
to  allow  the  plant  to  bear  its  own  extra  renewals  and  to  insist 
that  it  shall  always  be  kept  up.  Therefore  it  appears  that,  so  far 
as  concerns  the  future,  the  age  of  the  plant  should  not  be  a 
function  in  the  'rate  base.' 

(3V2)  On  the  other  hand,  in  computing  the  'rate  base'  from 
the  original  cost,  depreciation  is  of  vital  consequence.  Practical 
men  will  prefer  to  ascertain  the  cost  of  a  present  plant  by  experi- 
ence, when  they  can,  rather  than  by  estimate,  just  as  the  master 
here  has  done.  In  so  arriving  at  the  cost  of  a  present  plant  of 
equal  capacity,  it  is  clear  that  the  original  cost  of  the  plant  in 
question  must  be  abated  by  depreciation,  so  far  as  that  is  reflected 
in  a  loss  of  capacity.  In  such  a  calculation,  however,  there  must 
figure  past  renewals  as  an  offset  to  past  depreciation,  and,  if  in 
fact  the  capacity  has  remained  the  same,  depreciation  should  not 
be  a  function  of  the  'rate  base'  at  all.  In  such  a  case  the 
inquiry  as  to  depreciation  should  be  confined  to  changes  in 
'price  levels.' " 

This  case  was  passed  upon  by  the  Supreme  Court 

of  the  United  States  on  March  6,  1922 U.  S. 

Advance  Opinions,  April  15,  p.  306.  Justice  Mc- 
Reynolds  delivered  the  opinion.  Neither  the  basis 
of  valuation  nor  depreciation  is  discussed,  although 
the  opinion  quotes  from  the  Master's  report,  in- 
cluding the  following  paragraph: 


192    DEPRECIATION   OF  PUBLIC  UTILITIES 

"I  think  that  the  complainant  company  has  shown  itself,  clearly 
and  beyond  all  reasonable  doubt,  entitled  to  relief  from  the 
statutory  limitation  on  its  rates,  but  that  its  rate  of  return  should 
be  calculated,  not  upon  the  present  high  reproduction  cost  of  its 
property,  with  or  without  the  deduction  of  observed  or  actual 
depreciation,  in  whatever  manner  com^Duted,  but  upon  the  actual, 
reasonable,  investment  in  the  property  devoted  to  the  service  of 
the  complainant's  consumers." 

The  Supreme  Court  says:  "The  fundamental  question  pre- 
sented for  determination  was  whether  the  80  cent  rate  had  been 
confiscatory  under  conditions  existing  during  1918  and  1919  and 
probably  would  continue  so  to  be.  .  .  .  The  Master's  report  and 
opinion  disclose  careful  and  intelligent  consideration  of  the  whole 
matter.  'Resolving  all  doubts  against  the  plaintiff,'  and  using 
valuations  'pared  down  unsparingly,'  the  trial  court  agreed  with 
the  Master's  ultimate  findings  and  ruled  that  to  enforce  the  statute 
would  result  in  confiscation." 

The  decree  of  Judge  Hand,  while  not  reversed 
outright,  was  materially  modified,  affirmed  and  re- 
manded for  further  proceedings  in  conformity  with 
this  opinion. 

It  is  clear  that  the  Federal  decision  adds  nothing 
to  the  final  solution  while  the  Supreme  Court  opinion 
does  not  discuss  the  questions  here  being  considered. 

The  reasoning  of  Judge  Hand  is  quoted  as  a  mat- 
ter of  interest. 

Nashville  Chattanooga  and  St.  Louis  Ry.  Com- 
pany vs  United  States,  was  a  case  involving  the  cor- 
rectness of  the  government's  computations  of  the 
excise  tax  under  section  38  of  the  Revenue  Act  of 
Aug.  5,  1909. 

This  case  was  tried  twice  before  the  United  States 
Court  of  Appeals,  Sixth  Circuit,  both  decisions  being 
rendered  by  Judge  Knappen. 


APPENDIX  193 

The  first  opinion,  reported  In  249  Fed.  679  con- 
tains a  statement  of  the  character  of  questions  in- 
volving the  determination  of  depreciation: 

"We  have  not  overlooked  the  argument  that  the  ascertainment 
of  the  amount  of  net  income,  including  items  deductible  for 
'Operating  expenses,  and  for  losses  by  property  depreciation,  in- 
volves questions  of  fact,  to  be  determined  upon  testimony  and 
inferences  therefrom,  as  to  which  reasonable  minds  may  well 
differ.  But  this  does  not  make  their  determination  exclusively  a 
legislative,  as  distinguished  from  a  judicial,  act.  What  is  a  neces- 
sary expense  of  operation  and  what  is  a  reasonable  allowance  for 
property  depreciation  are  ultimately  questions  of  fact,  and  of 
no  different  kind  than  those  which  courts  are  trying  every  day. 
The  fact  that  their  determination  involves  personal  judgment 
does  not  make  to  the  contrary;  courts  and  juries  are  constantly 
deciding  kindred  questions  of  reasonable  care,  reasonable  cause, 
reasonable  delay,  reasonable  compensation,  and  reasonable  dis- 
bursements, all  of  which  involve  the  personal  judgment  of  the 
triers.  Such  questions  are  essentially  judicial;  so  far  as  they 
involve  legal  questions,  they  are  absolutely  so." 

The  second  opinion,  while  not  in  a  rate  case,  goes 
into  the  subject  of  depreciation  and  is  here  quoted 
at  length : 

Nashville,  Chattanooga  and  Saint  Louis  Railway 
Company  vs  United  States,  Circuit  Court  of  Ap- 
peals, Sixth  Circuit.  Dec.  7,  1920.  269  Fed.  351. 
Knappen,  Circuit  Judge: 

"This  case  is  before  this  court  a  second  time.  In  substance  it 
is  this:  In  June,  1916,  the  United  States,  under  the  direction  of 
its  commissioner  of  Internal  Revenue,  brought  suit  to  recover 
from  defendant  an  excise  tax  of  1  per  cent  claimed  to  be  due 
from  it  for  each  of  the  years  1909  and  1910,  under  section  38 
of  the  Revenue  Act  of  August  5,  1909  (36  Stat.  11,  112,  c.  6), 


194    DEPRECIATION   OF  PUBLIC   UTILITIES 

which  makes  every  corporation  to  which  it  applies  'subject  to 
pay  annually'  a  special  excise  tax  of  1  per  cent  ou  its  net 
income,  to  be  determined  by  deducting  from  gross  income,  among 
other  things,  operating  expenses,  losses  sustained,  'including  a 
reasonable  allowance  for  depreciation  of  property,'  interest  on 
indebtedness,  and  taxes.  The  declaration  alleged  the  filing  by 
defendant  with  the  Commissioner  of  Internal  Revenue,  on  Feb. 
25,  1910,  and  Feb.  21,  1911,  respectively,  of  returns  of  its  net 
income  for  the  respective  years  1909  and  1910 ;  that  both  returns 
were  incorrect  as  to  the  amount  of  defendant's  income — that  for 
1909,  in  that  it  included,  as  an  item  of  deduction  from  gross 
income,  an  alleged  charge  of  $2G,000  to  expenses,  which  was  not 
a  necessary  expense  actually  paid  out  of  income  in  the  main- 
tenance and  operation  of  its  business  and  properties;  those  for 
both  years,  in  that  they  included  charges  to  depreciation  of  road- 
way, amounting  to  $249,024.54  for  the  year  1909  and  $239,229.70 
for  the  year  1910,  which  were  not  charged  against  the  capital 
valuation  of  the  roadway  on  its  books,  and  were  not  reasonable 
allowances  for  depreciation  of  roadway  within  the  meaning  of  the 
act;  that  the  three  items  named  were  disallowed  by  the  Commis- 
sioner of  Internal  Revenue  and  held  by  him  to  be  incorrectly 
charged,  and  that  they  were  in  fact  not  correct  and  proper 
deductions  from  gross  income,  and  that  the  total  amounts  so 
deducted,  which  should  have  been  included  as  net  income  in  said 
returns,  were  for  the  year  1909  $275,024.54,  and  for  1910 
$239,229.70;  that  the  defendant  was  thus  indebted  to  the  United 
States  and  subject  to  pay  an  income  tax  of  1  per  cent  upon  the 
amounts  stated;  that  it  had  failed  and  refused  to  make  payment; 
and  that  the  alleged  taxes  were  thus  due  from  defendant  and 
payable  by  it  to  the  United  States." 


"Defendant  conceded  on  the  trial  that  the  deduction  of  the 
$26,000  item  in  its  return  for  1909  was  not  authorized.  The 
court  accordingly  properly  instructed  that  the  government  was 
entitled  to  a  verdict  for  at  least  $260  on  this  account.  The 
substance  of  the  charge  otherwise  was  that  the  question  of  fact 
to  be  determined  was  merely  whether  the  deductions  made  by 


APPENDIX  195 

defendant  in  its  excise  tax  reports  for  the  years  1909  and  1910, 
viz.  $249,024.54  for  the  former  year,  and  $239,229.70  for  the 
latter  year,  were  in  whole  or  in  part  reasonable  allowances  for 
depreciation  of  roadway  during  those  resi^ective  years;  that  if 
such  allowances  were  reasonable  the  government  is  not  entitled  to 
recover;  that  if  they  were  not  reasonable  the  government  was 
entitled  to  verdict  for  1  per  cent  of  the  amounts  improperly 
deducted.  The  jury  was  specifically  instructed  to  consider,  first, 
'the  depreciation,  either  physical  or  functional,  in  the  value  of 
those  parts  of  the  roadway  which  have  not  been  repaired  or 
renewed  or  replaced';  and,  second,  'what  haS'  been  the  effect  of 
the  repairs,  renewals,  and  replacements  that  have  been  made  to 
other  parts,  and  determine  whether,  after  you  strike  a  final  bal- 
ance at  the  end  of  the  year,  the  roadway  is  of  greater  or  less 
value,  or  of  equal  value,  than  or  to  that  which  it  was  at  the 
beginning  of  the  year,'  and  that  if  it  should  be  found  'that  the 
value  of  the  roadway,  its  actual  value,  is  as  great  at  the  end  of 
the  year,  after  these  repairs  and  replacements  have  been  made 
for  which  credit  has  been  given  as  an  expense  deduction,  then 
there  is  no  depreciation  in  value  of  .  .  .  the  roadway,  within  the 
meaning  of  the  statute,'  but  that  'if,  after  making  such  repairs, 
replacements,  and  renewals  in  the  different  units  of  the  roadway, 
it  should  be  found  that  some  jDarts  have  been  made  more  valuable 
by  the  putting  in  of  new  parts  in  place  of  wornout  parts,  yet  the 
depreciation  in  the  rest  of  the  roadway,  in  the  deterioration, 
obsolescence,  etc.,  of  other  units  which  have  not  been  changed, 
and  so  little  done  in  repairing  and  replacing  that  at  the  end  of 
the  year,  taking  it  as  a  whole,  the  depreciation  in  value  has  ex- 
ceeded the  repairs,  replacements,  and  renewals,  so  that  it  is  worth 
less  than  it  was  ...  to  that  extent  the  railway  is  entitled  to  a 
deduction  of  1  per  cent.' 

"The  first  specific  criticism  to  the  charge  is  that  depreciation 
was  made  to  depend  upon  the  relative  value  of  the  roadway  'in 
dollars  and  cents'  at  the  beginning  and  end  of  the  respective 
years.  The  contention  is  that  the  criterion  is  'earning  power,' 
'value  for  use,'  not  its  value  to  an  investor.  In  point  of  fact,  the 
court  did  not  use  the  expression  'dollars  and  cents'  in  its  charge 
to  the  jury.     Its  various  expressions  were  'value,'  'net  value,' 


196    DEPRECIATION   OF   PUBLIC   UTILITIES 

'actual  value/  'real  value,'  doubtless  meaning  intrinsic  value, 
value  in  'dollars  and  cents,'  as  distinguished  from  market  value, 
which  defendant's  testimony  showed  might  be  affected  by  con- 
siderations other  than  intrinsic  value. 

"The  criticism  is  without  merit.  Not  only  is  it  clear  that 
market  value  was  not  meant,  but  the  criticism  loses  all  point 
through  the  specific  admission  of  defendant's  counsel,  made  upon 
the  trial,  that  'the  road  as  a  whole,  for  the  purpose  of  carrying 
on  the  business  of  a  common  carrier,  was  just  as  valuable  at  the 
end  of  the  year  as  at  the  beginning,'  and  by  the  equally  express 
admission  of  defendant's  chief  engineer,  not  only  to  the  same 
effect  as  that  of  counsel,  but,  further,  that  it  would  be  worth  as 
much  to  'any  persons  that  wanted  to  buy  it  for  a  railroad.' 

"The  further  criticism  is  made  that  'the  court  refused  to  per- 
mit the  jury  to  consider  depreciation,  physical  or  functional,  in 
the  units  constituting  roadway,  track,  and  structures';  the  argu- 
ment being  that,  as  'a  railroad  is  a  composite  property,  it  is 
impossible  to  figure  depreciation  of  a  road  as  a  whole  without 
first  considering  depreciation  of  the  units.' 

"The  court,  however,  did  not  instruct  that  depreciation  of  units 
could  not  be  considered  in  determining  the  ultimate  question 
whether  there  was  not  depreciation  in  the  roadway  as  a  whole. 
It  is  true  that,  after  stating  that  there  would  be  no  depreciation 
if  repairs,  renewals,  and  replacements  had  placed  the  roadway  in 
the  same  value  as  at  the   beginning  of  the  year,  it  was  said: 

"  'In  that  sense  you  should  not  consider  each  of  the  individual 
units  that  enter  into  the  roadway.' 

"But  the  meaning  of  that  statement  was  made  clear  by  the 
paragraph  immediately  following: 

"  'It  was  not  intended  to  have  a  system  of  bookkeeping  with 
reference  to  each  particular  cross-tie  or  each  particular  rail,  but 
you  should  look  to  the  value  of  the  roadway  as  a  whole,  comparing 
its  value  at  the  beginning  of  the  ye«r  with  its  value  at  the  end  of 
the  year.' 

"Further  evidence  of  the  meaning  of  the  charge  appears  from 
the  later  use  of  the  term  'net  value' ;  also  by  earlier  reference  to 
the  making  of  repairs,  renewals,  and  replacements  in  the  road- 
way, by  'taking  out  units  that  had  decayed  or  whose  usefulness 


APPENDIX  197 

was  at  an  end  and  putting  in  others,  taking  out  cross-ties,  decayed 
cross-tics,  worthless  cross-tics,  and  putting  in  new  cross-ties, 
taking  out  rails  worn  out  and  putting  in  new  rails,  rej^airing  and 
replacing  different  units  in  its  roadway  system  from  time  to 
time,'  as  well  as  by  the  instruction  that  the  jury  should  consider 
'depreciation,  either  physical  or  functional,  in  the  value  of  those 
parts  of  the  roadway  which  have  not  been  repaired  or  renewed 
or  replaced,  then  also  consider  what  has  been  the  effect  of  the 
repairs,  renewals,  and  replacements  that  have  been  made  to  other 
parts,  and  determine  whether,  after  you  strike  a  final  balance  at 
the  end  of  the  year,  the  roadway  is  of  greater  or  less  value,  or  of 
equal  value,  than  or  to  that  which  it  was  at  the  beginning  of  the 
year.' 

"The  contention  on  which  defendant  seems  to  rest  its  chief 
criticism  seems  to  he  that,  notwithstanding  the  roadway  as  a 
whole  was  intrinsically  just  as  valuable  at  the  end  of  the  year  as 
at  the  beginning  of  the  year;  that  is  to  say,  although  depreciation 
in  given  units  had  been  fully  overcome  by  appreciation  in  others, 
the  railway  company  would  still  be  entitled  to  credit  for  deprecia- 
tion in  such  individual  units  as  had  depreciated.  We  think  this 
contention  of  defendant  not  sustained  by  reason  or  authority,  and 
that  the  court  correctly  charged  the  true  criterion.  If,  as  is  not 
entirely  clear,  it  is  meant  to  further  suggest  that  the  considera- 
tion of  functional  (as  distinguished  from  physical)  depreciation 
was  not  allowed  by  the  charge  to  be  taken  into  account,  the  sug- 
gestion is  plainly  without  merit.  Not  only  did  the  court  define 
the  roadway  as  including  'structures  connected  with  the  roadway, 
such  as  stations,  toolhouses,  and  matters  of  that  sort,'  but  it 
included  in  depreciation  a  lessening  of  original  values  'due  to 
wear  and  tear,  decay,  gradual  decline  from  obsolescence — that  is, 
getting  out  of  date  and  inadequacy.'  In  our  opinion  the  jury 
was  given  the  correct  rule  for  determining  the  existence  or  non- 
existence of  depreciation,  which  accords  with  the  'ordinary  and 
usual  sense'  of  that  term  'as  understood  by  business  men.'  Van 
Baumbach  vs  Sargeant  Land  Company,  242  U.  S.  503,  524,  37 
Sup.  Ct.  201,  61  L.  Ed.  460.  To  say  that  property  can  depreciate 
without  impairment  of  either  intrinsic  value  or  efficiency  is  to  our 
minds  a  solecism. 


198    DEPRECIATION   OF   PUBLIC   UTILITIES 

"3.  The  Refusal  to  Direct  Verdict. — The  sole  question  in  this 
regard  is  whether  or  not  there  was  substantial  testimony  tending 
to  support  the  government's  contention  that  tliere  was  during  the 
years  1909  and  1910  no  net  depreciation  in  the  intrinsic  value  of 
the  roadway  and  structures  considered  as  a  unit.  It  is  not  highly 
important  to  the  determination  of  this  question  whether  the  con- 
troversy arose  on  one  theory  and  was  tried  on  another,  nor 
whether  the  claimed  depreciation  would  have  been  allowed  under 
the  system  of  bookkeeping  employed  by  the  government,  had  the 
charges  therefor  been  set  uj)  on  the  railway  comjDany's  books, 
249  Fed.  at  page  686,  161  C.  C.  A.  588. 

"It  appears  that  defendant  arrived  at  the  depreciation  charges 
by  estimating  the  value  of  the  perishable  structures  as  one-third 
the  cost  of  the  road  (less  equipment  and  real  estate),  and  then 
taking  3  per  cent  of  this  one-third  value,  on  the  theory  that  the 
average  life  of  the  various  perishable  elements  was  33%  years. 
Whether  or  not  these  depreciation  estimates  were  reasonable  was 
a  question  for  the  jury. 

"In  our  opinion  there  was  substantial  testimony  tending  to  Sup- 
port the  government's  contention.  It  appeared  that  there  was 
expended  in  round  numbers  for  maintenance  of  way  and  struc- 
tures— that  is  to  say,  for  repairs,  renewals  and  replacements — 
for  the  year  1909  of  $1,600,000,  and  for  the  year  1910  of 
$1,554,000,  and  that  no  substantial  part  of  these  sums  was  carried 
in  defendant's  accounting  as  additions  and  betterments.  It  was 
admitted  by  defendant's  chief  engineer  that  the  expenditures  for 
1909  'kept  the  road  in  a  normal  condition  to  carry  on  its  business,' 
that  'its  normal  condition  was  a  good  condition,'  and  that  the 
expenditures  'had  made  good  the  normal  amount  of  depreciation.' 
There  was  testimony  hy  competent  witnesses  of  railway  experi- 
ence that  'there  may  he  depreciation  in  the  units  comprising  the 
roadway,  track  and  structures  of  the  railroad,  while  there  is  no 
depreciation  in  the  machine  as  a  whole';  also  that  'it  is  possible 
to  maintain  the  roadway,  track,  and  structures,  so  that  there  will 
be  no  depreciation  if  we  consider  the  roadway,  track,  and  struc- 
tures as  a  composite  whole';  also  that  'the  service  life  of  any 
normally  operated  and  normally  and  well  maintained  railroad  is 


APPENDIX  199 

perpetual,  and  it  is  maintained  in  the  condition  of  property 
serving  its  purpose  by  annual  renewals  and  replacements.' 

"The  testimony,  considered  as  a  whole,  tended  to  support  the 
conclusion  that  the  amounts  exjjended  by  defendant  during  the 
years  in  question  for  repairs,  renewals,  and  replacements  should 
and  would  have  fully  offset  the  depreciation  in  the  various  units, 
and  that  the  defendant's  railway  and  structures  were,  as  a  whole, 
maintained  throughout  the  years  in  question  in  fully  as  good  con- 
dition, and  were  of  fully  as  great  intrinsic  value,  as  at  the  begin- 
ning of  the  respective  years.  The  jury  would  have  been  clearly 
justified  in  inferring  from  the  testimony  of  defendant's  chief 
engineer,  taken  as  a  whole,  that  the  value  of  the  roadway  had  not 
depreciated  during  the  two  years  in  question ;  in  other  words,  that 
the  repairs  and  renewals  that  had  been  made  were  of  such  a 
character  as  to  leave  the  road  at  the  end  of  each  year  of  value 
equal  to  that  at  the  beginning  of  the  year.  That  officer's  testi- 
mony so  impressed  the  trial  judge,  who  stated  his  opinion  from 
the  evidence  that  'there  is  no  reasonable  deduction  for  deprecia- 
tion established.'  Defendant  did  not  directly  controvert  the  situa- 
tion so  shown.  Its  chief,  if  not  its  only,  reliance  seems  to  have 
been  on  the  proposition  that,  in  spite  of  it  all,  there  was  inevitable 
annual  depreciation  in  some  of  the  perishable  elements  not  en- 
tirely renewed  or  replaced,  so  justifying  the  contention  that  for 
this  reason  there  was  depreciation  within  the  meaning  of  the 
act,  even  though  the  roadway  as  a  whole  had  not  decreased  in 
value.  To  this  argument,  as  rightly  said,  we  cannot  assent.  It 
follows  that  the  trial  judge  rightfully  refused  to  instruct  verdict 
for  defendant. 

Finding  no  error  in  the  record,  the  judgment  of  the  District 
Court  is  affirmed.     (Italics  ours.) 

The  Queens  County  Gas  case  is  of  special  interest 
in  view  of  the  thorough  discussion  of  depreciation 
by  the  master.  The  approval  of  the  master's  find- 
ings by  the  District  Court,  and  the  affirmation  of 
that  decree  by  the  Supreme  Court  seem  to  entitle 
this  report  to  most  careful  consideration. 


200    DEPRECIATION  OF  PUBLIC  UTILITIES 

New  York  and  Queens  Gas  Company  vs  Newton 
269  Fed.  277.  District  Court  C.  D.  New  York,  Dec. 
13,  1920.    Mayer,  Dist.  Judge. 

The  opinion  of  the  court  in  this  case  is  very  brief 
and  only  touches  upon  one  or  two  subjects  not  in- 
cluding depreciation.  He  approves  the  report  of 
Special  Master  Abraham  S.  Gilbert  as  follows: 

"Examining,  then,  this  record  and  the  special  master's  report, 
it  is  apparent  that  discussion  is  necessary  only  in  respect  of  the 
more  important  features.  Many  of  the  details  have  been  care- 
fully and  correctly  disposed  of  by  the  master  in  his  comprehensive 
report,  which  fully,  though  concisely,  has  dealt  with  the  essential 
features  of  the  testimony.  Repetition,  in  this  opinion,  of  certain 
findings  and  of  the  reasons  in  support  thereof  is  not  requisite, 
and  it  is  enough  to  indicate  approval  of  those  findings." 

The  report  of  the  special  master  deals  with  the 
subject  of  depreciation  in  the  following  language : 

"No  Reduction  for  'Accrued  Theoretical  Depreciation.' — In  de- 
termining that  the  complainant's  property  has  a  fair  present 
value  of  at  least  the  amount  of  the  complainant's  actual  invest- 
ment therein  as  found  by  me,  viz.  at  least  $1,655,887.94,  I  have 
made  no  deduction  for  what  is  termed  'depreciation,'  in  whatever 
way  calculated.  Under  any  basis  of  determining  present  value, 
the  complainant's  property  is  now  worth  at  least  the  amount  of 
such  investment  therein,  and  the  sound  rule  of  law  and  policy 
seems  to  require  the  allowance  of  a  reasonable  return  upon  at 
least  that  sum. 

"Upon  the  present  trial,  it  was  insistently  urged  upon  me  by 
some  of  the  defendants  that  there  should  be  deducted  from  the 
cost  of  the  property  (irrespective  of  whether  'original,'  'pre-war,' 
or  'present  reproduction'  cost  be  under  consideration)  an  amount 
claimed  to  represent  so-called  'accrued  theoretical  depreciation,' 
based  upon  an  assumption  of  'life  expectancy'  for  a  gas  plant  and 


APPENDIX  201 

equipment  and  the  estimated  or  known  number  of  years  since  the 
same  was  erected  or  installed.  From  the  testimony  given  upon 
the  trial,  I  was  strongly  impressed  that,  in  respect  of  a  very  large 
proportion  of  gas  property,  there  is  no  ascertainable  'life  ex- 
pectancy.' The  withdrawal  of  such  property  from  service  comes 
about  from  inadequacy  or  obsolescence,  which  cannot  be  forecast 
in  terms  of  years  or  even  satisfactorily  guessed  at.  Certain  parts 
of  operating  machinery  and  equipment  are  of  course  subject  to 
the  effects  of  use.  The  replacement  of  those  wearing  parts  enters 
into  the  cost  of  repairs.  As  to  the  substantial  units  of  structures, 
apparatus,  mains,  and  equipment,  their  witlidrawal  from  the 
property  accounts  comes  about  from  causes  not  attributable  to  the 
condition  of  the  property  itself,  or  any  diminution  in  its  operat- 
ing efficiency,  but  varying  utterly  with  the  particular  plant,  time, 
local  conditions  and  service  demands,  and  hence  capable  of  being 
forecast  only  as  the  occasion  for  such  change  in  plant  or  equip- 
ment becomes  imminent. 

"The  Renewal  and  Replacement  of  Gas  Property. — In  other 
words,  in  order  to  keep  abreast  of  improvements  in  the  art  of 
making  and  distributing  gas  when  and  as  it  becomes  economically 
advantageous  to  do  so,  and  to  meet  the  growing  demand  of  the 
public  for  service  more  adequately  and  economically  than  would 
be  possible  tlirough  merely  making  additions  and  extensions  to 
existing  plant  and  equipment,  larger  or  better  and  more  econom- 
ical and  efficient  units  of  plant  and  equipment  are  from  time  to 
time  installed,  to  take  the  place  of  units  which  are  still  operating 
as  efficiently  as  when  first  installed.  The  loss  due  to  such  super- 
session cannot  properly  he  said  to  have  accrued  during  the  period 
the  superseded  unit  was  in  service.  It  occurred  when  superses- 
sion took  place.  It  became  a  proper  charge  against  the  economies 
to  be  realized  therefrom.  It  furnished  no  basis  for  the  imposition 
of  an  additional  charge  against  the  user  of  the  superseded  unit 
during  the  period  of  its  useful  service,  over  and  above  the  higher 
cost  of  operating  it.  Such  a  charge  could  not  he  justified,  either 
on  the  ground  that  the  unit  was  losing  potential  life,  or  that  the 
capital  invested  in  it  was  being  consumed,  because  neither  is  true. 

"Additional  Burden  on  the  Consumer  Unwarranted. — In  order 
to  justify  the  deduction  of  'theoretical  depreciation/  I  was  asked 


202    DEPRECIATION   OF   PUBLIC   UTILITIES 

in  this  case  to  assume  that  'a,  depreciation  reserve'  equal  to  the 
computed  'theoretical  depreciation'  had  been  collected  from  the 
public,  and  then  to  deduct  from  the  company's  investment  the 
amount  of  such  assumed  reserve.  No  such  reserve  had,  in  fact, 
been  collected  or  accumulated  by  this  company.  The  rate  charge- 
able did  not  permit  it,  and  there  is  no  reason  to  believe  that  the 
Legislature,  in  j^reseribing  the  rate,  ever  contemplated  it.  As  I 
have  net  forth  in  findings  Nos.  32  and  27  of  my  report,  and  as 
I  have  elsewhere  indicated  herein,  the  complainant  gas  company 
has  maintained  its  property  and  investment  intact  in  the  past, 
through  renewals  and  replacements,  at  an  average  actual  cost  of 
approximately  .3  cents  jier  1000  cubic  feet  of  gas  sold,  and  no 
reason  appears  for  believing  that  it  cannot  continue  to  do  so  on 
that  basis.  Even  assuming  that  the  statute  permitted  such  a  rate, 
to  have  imposed  on  the  company's  consumers  an  additional  bur- 
den nearly  twice  as  great,  representing  a  jjurely  theoretical  item 
of  operating  cost,  merely  to  accumulate  a  useless  reserve  to 
justify  a  drastic  deduction  from  investment  in  some  ultimate  pro- 
ceeding as  to  rates,  could  not  have  been  justified  on  any  sound 
theory  in  the  past,  and  cannot  now  be  sustained  as  to  the  future. 
"Effects  of  an  Unnecessary  Reserve. — In  order  to  justify  the 
assumi^tion  that  a  'depreciation  reserve'  was  or  should  have 
been  collected,  defendants'  witness  Hine  testified  in  this  case  that 
such  a  reserve  was  necessary,  'so  that  when  the  property  is  retired 
for  any  cause  whatsoever  the  fund  can  be  charged  with  the  cost 
of  the  property.'  He  testified,  also,  that  the  reserve  should  be  in 
his  opinion  'invested  in  the  property,'  and  that  when  the  funds 
were  needed  for  renewals  and  replacements  they  would  be  pro- 
vided 'by  issuing  securities  against  construction  work  which  had 
been  done  originally  out  of  this  fund,  for  the  money  laid  aside 
for  this  fund,  just  to  reimburse  the  treasury  on  account  of  these 
expenditures.'  This  view  seemed  to  me  to  disregard  the  obvious 
fact  that,  having  deducted  the  amount  of  the  reserve  temporarily 
invested  in  property  from  that  on  which  he  proposed  the  company 
should  be  allowed  to  earn  a  return,  he,  to  all  intents  and  purposes, 
destroyed  the  earning  power  of  such  property,  and  investment; 
that  therefore  he  could  not  issue  any  securities  against  such  prop- 
erty,   there   being  no   earnings   therefrom   with    which   to   pay 


APPENDIX  203 

interest  on  the  securities;  that  the  reserve  could  never  thereafter 
be  availed  of  for  the  purpose  for  which  it  was  alleged  to  have 
been  created;  and  that  it  would  be,  in  fact,  as  if  it  had  never 
been  created.  Thus  he  not  only  failed  to  sustain  his  contention 
that  a  'depreciation  reserve'  was  necessary  for  the  purpose  which 
he  alleged,  but  he  proposed  to  treat  the  reserve  as  if  he  himself 
believed  it  to  be  both  unnecessary  and  ineffectual,  except  for  the 
purpose  of  justifying  a  deduction  from  the  complainant's  invest- 
ment. 

"It  is  obvious  that  the  collection  of  an  unnecessary  reserve  and 
its  periodic  deduction  from  the  value  of  the  property  in  service 
would  operate  to  effect  a  piecemeal  purchase,  on  the  part  of  the 
public,  of  the  property  used  by  the  utility  in  its  service.  In  other 
words,  it  is  really  asking  the  consumer  to  pay  for  the  plant,  in- 
stead of  paying  a  return  on  the  investment.  If  such  a  consum- 
mation is  desirable,  of  which  there  is  no  evidence,  it  should  be 
effected  openly,  and  not  suiTeptitiously,  under  the  guise  of  pro- 
viding for  so-called  'theoretical  depreciation.' 

^'Present  Condition  of  the  Property. — Mr.  Miller  testified  that, 
as  of  April,  1920,  the  expenditure  of  $6,144.07  for  repairs,  re- 
newals, and  replacements,  would  put  the  plant,  structures,  ma- 
chinery, and  equipment  in  condition  substantially  as  good  as  when 
they  were  erected  or  installed.  His  testimony  in  this  respect  was 
not  contradicted  by  that  of  any  witness.  This  sum,  however,  does 
not,  in  my  opinion,  measure  any  imj^airment  in  the  present  value 
of  the  property  used  and  useful  in  the  gas  business.  It  represents 
merely  an  unmatured  obligation  to  maintain  the  property  in 
efficient  operating  condition  out  of  future  earnings;  the  expert 
witnesses  of  both  the  complainant  and  the  defendants  agi'eeing 
that  it  was  and  is  maintained  in  efficient  and  first-class  condition. 
I  therefore  have  not  deducted  this  or  any  other  sum  representing 
so-called  'accrued  depreciation'  from  the  amount  found  by  me  to 
represent  the  investment  of  the  complainant  in  its  gas  property 
upon  which  it  is  entitled  to  have  its  rate  such  as  to  yield  a  reason- 
able return." 

Inasmuch  as  the  Federal  Court  quotes  the  Mas- 
ter's report  in  full  and  accepts  it,  so  far  as  it  re- 


204    DEPRECIATION   OF   PUBLIC  UTILITIES 

lates  to  depreciation,  without  comment  or  modifica- 
tion, the  final  acceptance  of  this  decree  by  the 
Supreme  Court  on  review  of  the  case  entitles  it  to 
great  weight. 

Newton  vs  New  York  and  Queens  Gas  Company, 
decided  March  6,  1922,  U.  S.,  Advance  Opinions, 
April  15,  p.  309.     Opinion  by  Justice  McReynolds. 

The  opinion  is  short,  only  two  paragraphs.  The 
second  refers  to  the  Master's  report  and  conclusion 
that  the  rate  was  confiscatory,  and  says: 

"With  this  conclusion  the  trial  court  agreed,  and  entered  an 
appropriate  decree.  We  find  no  sufificient  ground  for  disap- 
proving the  action  so  taken,  and  it  is  accordingly  affirmed." 

The  case  of  Galveston  Electric  Company  vs  City 
of  Galveston  tried  before  the  District  Court,  S.  D. 
Texas,  Feb.  10,  1921,  reported  in  272  Fed.  on  p.  147, 
and  affirmed  by  the  United  States  Supreme  Court  in 
Galveston  Electric  Company  vs  Galveston,  decided 
April  10,  1922,  reported  in  Advance  Opinions,  May 
15,  1922,  constitutes  the  last  word  spoken  by  the 
Supreme  Court  on  the  subjects  of  Valuation  and 
Depreciation. 

The  Federal  decision  was  rendered  by  District 
Judge  Hutcheson.  In  passing  on  the  motion  for 
rehearing,  April  27,  1921,  he  discusses  depreciation 
on  pp.  168  to  171  as  follows: 

"The  record  shows  that  the  overheads,  such  as  interest  during 
construction,  engineering,  law  expenses,  etc.,  were  arrived  at  by 
the  parties  by  taking  a  certain  percentage  upon  the  estimated  cost 
of  the  physical  properties.    It  must  necessarily  follow,  then,  that/ 


APPENDIX  205 

if  the  physical  properties  entering  into  the  cost  of  the  property 
are  appreciated,  the  overhead  items  will  be  correspondingly  in- 
creased, as  the  necessary  result  of  applying  the  same  percentage 
figures  to  the  increased  amount  of  money  involved.  Or,  putting 
it  otherwise,  for  the  jiurpose  of  this  calculation,  the  synthetic 
process  is  employed,  and  the  overheads  are  not  treated  as  distinct 
items,  but  as  parts  of  a  complete  whole,  and  while  I  do  not  find 
that  the  items  of  overhead,  such  as  interest  during  construction, 
have  appreciated  in  cost,  or  that,  viewed  as  items  apart  from  the 
physical  property,  there  should  be  any  appreciation  applied  to 
them,  I  do  find  that,  when  the  base  which  is  used  to  find  the 
amount  of  these  items  by  the  application  of  percentage  is  in- 
creased, the  sum  of  these  items  must  necessarily  itself  increase. 

"On  the  other  hand,  when  the  matter  of  establishing  the  de- 
preciation annuity  is  considered,  the  analytic  process  is  employed, 
and  the  sum  total  of  the  value  of  the  plant  is  resolved  into  its 
constituent  items,  so  as  to  select  those  items  making  up  the  whole 
which  are  susceptible  to  depreciation.  Under  the  influence  of 
this  process  it  is  clear  that  the  overhead  items  must  be  discarded 
in  arriving  at  the  annual  depreciation  allowance. 

"That  this  disposition  is  sound  as  to  such  items  as  interest  dur- 
ing construction^  organization  expense,  law  expense,  etc.,  admits 
of  no  doubt,  because  under  no  kind  of  theory  could  they  he  sup- 
posed to  be  subject  to  depreciation,  and  ivhat  doubt  might  arise 
with  reference  to  the  propriety  of  including  engineering  charges 
in  these  figures  is  at  once  dissipated  when  it  is  considered  that 
the  property  will  not  be  constructed  again  as  an  entirety,  but  is 
to  he  kept  up  by  annual  renewals  from  time  to  time  made,  so 
that  engineering,  and  other  such  overheads  caused  hy  the  assem- 
bling of  the  plant,  will  not  have  to  he  provided  against,  because 
they  will  not  he  again  incurred. 

"In  short,  while,  if  the  object  of  the  depreciation  annuity  were 
to  provide  a  fund  sufficient  at  the  end  of  a  period  of  years  to 
replace  the  plant  as  an  entirety,  the  percentage  ought  to  be 
figured  on  the  entire  cost  of  the  plant,  including  the  overheads 
necessarily  incurred  in  assembling  it,  since  the  object  is  otherwise, 
and  merely  contemplates  the  provision  of  a  fund  out  of  which 
annual  renewals  and  replacements  can  be  made,  none  of  these 


206    DEPRECIATION   OF   PUBLIC   UTILITIES 

items  ought  to  be  considered  in  arriving  at  the  annuity  rate,  for 
the  same  organization  which  runs  the  plant,  the  expense  of  which 
is  provided  for  in  the  annual  operating  expenses,  looks  after,  pro- 
vides for,  and  takes  care  of  the  renewals. 

"The  result  of  these  views  requires  the  complete  rejection  by 
the  court  of  the  figure  of  $1,300,000,  taken  in  the  original  opinion 
as  the  basis  for  the  4  per  cent  depreciation  annuity,  and  the 
substitution  therefor  of  the  correct  figure,  $1,000,000,  which  is 
arrived  at  in  accordance  with  these  views,  to  which  must  be 
added  $131,000  of  new  physical  items  overlooked  by  the  court  in 
the  former  opinion,  making  a  total  figure  for  the  basis  of  depre- 
ciation allowance  of  $1,131,000. 


"Maintenance 

"In  the  original  opinion  the  excessive  increases  in  maintenance 
over  the  year  1918  were  disallowed  by  the  court,  and  it  was 
stated  that  an  allowance  of  $70,000  on  that  score  would  be  liberal. 
The  arguments  on  the  motion  for  rehearing  have  not  changed,  but 
have  confirmed,  that  view. 

"While  the  data  before  the  court  did  not  permit  of  the  absolute 
deduction,  the  court  was  of  the  opinion  that  the  excessive  ad- 
vances in  maintenance  were  explained  by  the  fact  that  main- 
tenance had  been  confused  with  depreciation  or  replacement 
account,  and  that  the  shadowy  difference  between  depreciation 
and  maintenance,  which  exists  in  some  classes  of  expenditure,  had 
disappeared,  with  the  result  that  the  company  was  charging  to 
maintenance  items  which  ought  to  have  been  taken  care  of  in 
replacement  or  depreciation  account.  I  was  led  to  this  conclusion 
by  the  fact  that,  while  maintenance  costs  were  mounting  higher 
and  higher,  the  operating  costs  did  not  correspondingly  increase. 

"Counsel  for  complainant  lay  the  difficulty  at  the  door  of  what 
they  call  'deferred  maintenance,'  and  claim  that,  unless  they  are 
now  allowed  a  sufficient  return  to  take  care  of  this  deferred  main- 
tenance, it  must  come  out  of  the  stockholders,  which  they  claim 
is  unjust.    To  this  position  the  answer  suggests  itself  that,  as  to 


APPENDIX  207 

maintenance  and  depreciation,  in  paraphrase  of  John  Dryden, 
it  may  be  said : 

'Maintenance  is  sure  to  depreciation  near  allied, 
And  thin  partition  walls  their  bounds  divide,' 

and  that  if  this  maintenance  has  been  deferred  as  much  and  as 
long  as  they  claim,  it  has  by  this  time  become  depreciation,  and 
the  total  of  the  sums  of  deferred  maintenance  might  with  pro- 
priety be  subtracted  from  the  valuation  of  the  property,  because 
the  money  represented  in  those  figures  is  either  in  the  property 
or  is  not  in  it,  and  this  valuation  has  assumed  that  the  company's 
property  was  in  proper  rei^air. 

"I  am  inclined,  however,  to  the  view  that  the  disposition  of 
this  item  by  deducting  these  sums  from  the  capital  value  would 
not  be  accurate  or  just,  and  that  the  proper  disposition  of  it  is  to 
treat  it  as  what  the  company  in  fact  claims  it  is,  deferred  main- 
tenance, at  least  until  such  time  as  the  company  has  had  an 
opportunity  to  restore  the  property  to  its  proper  operative  con- 
dition, by  putting  into  it  the  'deferred'  maintenance  called  for 
by  their  own  figures. 

"Upon  no  view  of  it  should  the  public  be  required  to  pay  such 
rates  as  would  permit  the  company,  at  the  public's  expense,  to 
re-establish  its  property  in  the  condition  it  ought  to  have  been 
maintained  in.  The  language  of  the  Supreme  Court  in  the  Knox- 
ville  Water  Co.  case  has  application  here : 

"  'If  however,  a  company  fails  to  perform  this  plain  duty, 
and  to  exact  sufficient  returns  to  keep  the  investment  unimpaired, 
whether  this  is  the  result  of  unwarranted  dividends  upon  over- 
issues of  securities,  or  of  omission  to  exact  proper  prices  for 
the  output,  the  fault  is  its  own.' 

"For  there  can  be  no  difference  between  the  effort  to  increase 
the  value  of  the  property  through  a  recital  of  past  failures  to 
make  replacements,  and  the  effort  to  increase  the  rate  of  return 
in  order  to  put  back  into  the  treasury  moneys  to  take  care  of 
deferred  maintenance.  I  am  convinced,  therefore,  that,  whether 
this  excess  maintenance  is  due  to  confusing  maintenance  with 
replacement  cost,  or  to  a  condition  of  'deferred  maintenance,'  the 


208    DEPRECIATION  OF  PUBLIC  UTILITIES 

so-called  'actual'  maintenance  expenditure  cannot  be  allowed  in 
determining  whether  the  rate  is  confiscatory,  but  there  should  be 
taken  an  annual  sum,  arrived  at  ui:)on  a  consideration  of  all  the 
factors  which  enter  into  the  problem,  in  the  light  of  the  history 
of  the  company,  and  in  that  light  I  have  allowed  $70,000,  which 
seems  to  me  to  be  at  present  ample,  and  which,  if  prices  continue 
to  fall,  will  soon  become  itself  excessive." 

The  Supreme  Court  decision,  April  10,  1922,  re- 
ported in  Advance  Opinions,  May  15,  p.  383,  by 
Justice  Brandeis  says,  bearing  on  this  subject: 

''The  company  asked  to  have  allowed  as  a  further  charge 
$29,500  a  year  on  account  of  what  is  called  deferred  maintenance. 
The  contention  is  that  during  the  war  and  two  years  following, 
the  company  had  deferred  maintenance,  pursuant  to  a  policy 
established  at  the  express  request  of  the  government  to  the  end 
that  material  and  labor  might  be  released  for  war  purposes;  that 
to  make  good  this  deferred  maintenance  would  cost  $197,000; 
and  that,  in  order  to  amortize  this  amount,  an  annual  allowance 
from  earnings  of  $29,500  should  be  made  for  five  years.  This  is 
an  attempt,  in  another  form,  to  capitalize  alleged  past  losses ;  and 
the  request  was  properly  refused  both  by  the  master  and  the 
court." 


THE    END 


TABLE  OF  CASES  AND  REFERENCES 

Pages 
American     Society    of    Civil     Engineers' 

Committee   on   Valuation,   Report   of, 

Trans.  A.  S.  C.  E.,  Vol.  LXXXI 33,  36,  68,  69,  117, 

129,  131 
Brooklyn    Borough    Gas    Co.    vs    Public 

Service  Com.,  P.  U.  R.  1918F 45,  46 

Brymer   vs   Butler   Water   Co.,   179    Pa. 

State  231 157 

Carter,  Robt.  A.  &  Ransom,  W.  L.    Mem- 
orandum to  I.  C.  C 59,  90,  129,  134 

Consolidated  Gas  Co.  vs  Newton,  267  Fed. 

231 48,  49,  190 

Cumberland    Telephone    Co.    {La.   R.   R. 

Com.  vs  Cum.  Tel.  Co.),  212  U.  S.  414     16,  22,  72,  169 
Galveston  Electric  Co.  vs  Galveston,  272 

Fed.  147  . . .  U.  S.  . . .  Adv.  Opinions, 

May  15,  1922,  382 51,  53,  76,  204 

Goddard,  Edwin  C,  Mich.  Law  Review, 

Jan.,  1917 59 

Hatfield,  H.  R.,  "Modern  Accounting"..     68 
Hooper,  Wm.  E.,  "Railroad  Accounting"     68,  94 
Houston  vs  Southwestern  Bell   Tel.   Co., 

. . .  U,  S.  . . .  Adv.  Opinions,  May  29, 

1922 55 

Kansas  City  Southern  Ry.  Co.  vs  U.  S., 

231  U.  S.  423 23,  73,  110,  139,  181 

Knoxville    Water   Co.   vs   Knoxville,   212 

U.   S.   1 15,  70,  107,  108,  163 

209 


210  TABLE  OF  CASES  AND  REFERENCES 

Pages 

Landon  vs  Kansas  Court  of  Industrial  Re- 
lations, P.  U.  R.  1921A-807 49 

Laporte  Gas  &  Elec.  Co.  ease,  P.  U.  R. 
1921A-824    56 

Lincoln  Gas  <&  Elec.  Lt.  Co.  vs  Lincoln, 

223  U.  S.  349 15,  73,  122,  174 

Lincoln  Gas  &  Elec.  Lt.  Co.  vs  Lincoln, 
250  U.  S.  256 47 

Louisiana  R.  R.  Com.  vs  Cumberland  Tel. 

&  Tel.  Co.,  212  U.  S.  414 16,  22,  72,  169 

Mackintosh  vs  F.  £  P.  M.  Ry.,  34  Fed.  583     152 

Minnesota  Rate  Cases.  See  Simpson  et  al 
vs  Shepherd 

Milwaukee  Electric  Ry.  &  Lt.  Co.  vs  Mil- 
waukee, 87  Fed.  577 158 

Newton  vs  C onsolidated  Gas  Co.,  ... 
U.  S.  ...  Adv.  Opinions  Apl.  15,  1922, 
305 191 

Newton  vs  New  York  &  Queens  Gas 
Co.  ...  U.  S.  ...  Adv.  Opinions 
Apl.  15,  1922,  309 54 

New  York,  Lake  Erie  &  Western  R.  R.  vs 

Nickals,  119  U.  S.  296 151 

New  York  <&  Queens  Gas  Co.  vs  Newton, 

269  Fed.  277 54,  75,  123,  139,  200 

Nashville,  C.  (&  St.  L.  Ry.  vs  U.  S.,  269 

Fed.  351 15,  74,  124,  192,  193 

Paton  &  Stevenson,  "Principles  of  Ac- 
counting"        68 

Perkins  vs  Northern  Pacific,  155  Fed.  445     160 

Pioneer  Tel.  &  Tel.  Co.  vs  State,  167  Pac. 

995 91,  187 

Ransom,    Wm.    L.    &    Robert    L.    Carter, 

Memorandum  to  I.  C.  C 59,  90,  129,  134 

Reagan  vs  Farmers'  Loan   &    Trust  Co., 

154  U.  S.  362 72,  153 


TABLE  OF  CASES  AND  REFERENCES  211 

Pages 
Eedlands  Water  Co.  vs  Redlands,  121  Cal. 

312 158 

St.  Joseph  Light,  Heat  &  Power  Co.,  P.  U. 

R.  1921A  540 48 

San  Diego  Land  &  Town  Co.  vs  Jasper, 

189  U.  S.  439 159 

San  Diego  Land  &  Town  Co.  vs  National 

City,  174  U.  S.  739. .    159 

San  Diego  Water  Co.  vs  Sa7i  Diego,  118 

Cal.  556 155 

Simpson  et  al  vs  Shepherd,  The  Minnesota 

Rate  Cases,  230  U.  S.  352 15,  43,  44,  109,  177 

Smyth  vs  Ames,  The  Nebraska  Rate  Case, 

169  U.  S.  466 43,  71 

Stevenson,   Paton   &,   "Principles   of  Ac- 
counting"       68 

Southern  Pacific  vs  Bd.  of  R.  R.  Com.,  78 

Ted.  236 154 

Union  Pacific  R.  R.  vs  U.  S.,  99  U.  S.  402     148,  150,  154 
United  States  vs  Kansas  Pacific  R.  R.,  99 

U.  S.  455 71,  150,  157 

Vail,  Theodore  N.,  Report  to  Stockholders 

A.  T.  &  T.  Co 78,  133 

Willcox    vs   Consolidated    Gas    Co.,    212 

U.  S.  19 43 

Young,   Allyn   A.,   Quarterly  Journal  of 

Ecan.,  Aug.,  1914 86 


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